Bye bye Goldilocks, investors are headed into a reflationary scenario

Dubai: As the name suggests, the effect of goldilocks on global asset markets was extremely positive as a combination of low inflation and falling market volatility, helping drive returns higher in recent years. Equity market volatility, as measured by the S&P500 VIX index, reached a cyclical-low of 9.1 in November 2017 and traded in a range of 10-15 for most of the year. After the spike in market volatility in February 2018, when it rose as high as 37 on a closing basis, we believe we have entered a new era for market volatility, with the VIX likely to trade in a range of 15-20 in 2018.

Inflation, as measured by the US core consumer price index has also passed the low for this cycle, which was recorded in August 2017 at 1.7 per cent and is currently 1.8 per cent. While inflation will continue to rise, we believe that structural factors including demographics and job insecurity are likely to limit the upside.

The combination of moderately higher bond yields and increased volatility has significant implications for investors as it implies that the sweet spot in global equity and bond markets is behind us. We are now firmly in the reflationary part of the economic cycle, which has been historically consistent with positive equity market performance.

Amid these changes, there is one other important positive: a moderately weaker USD. Asia ex-Japan and Emerging Markets ex-Asia have historically been significant beneficiaries of US dollar weakness. The transition mechanism of a weaker US dollar on asset prices in Emerging Markets is via local policymakers’ desire to limit the upside in their local currencies. This has the effect of increasing domestic liquidity as central banks release local currency to buy US dollars to hold down the value for their local currencies. While some of the increase in local currency supply can be absorbed via issuing bonds, it generally has the effect of increasing domestic liquidity and holding interest rates lower than would otherwise be the case.

Most preferred market

We continue to view equities as our preferred asset class, indicating that investors should have an above benchmark allocation. Asia ex-Japan is our most preferred market globally, reflecting a combination of factors including: forecast earnings growth of 13 per cent in 2018, fair valuations at 13x 2018 consensus earnings forecast and the positive effect from a weaker US dollar. Within Asia ex-Japan, China stands as our most preferred market. Factors leading us to be positive on China include: financial de-leveraging, which is reducing the risks in the financial sector, rising Southbound flows from Stock Connect, which now accounts for 15 per cent of turnover in the Hang Seng index, up from 10 per cent last year. Consensus forecast earnings growth is also attractive at 15 per cent for 2018.

The impact of Stock Connect on the Hong Kong market and in particular Chinese shares listed in Hong Kong should not be under-estimated. Chinese investors are steady buyers of stocks in the financial and technology sectors, focusing on those companies which are not accessible in the domestic A share market. We expect the share of Hang Seng index turnover accounted for by Stock Connect to steadily rise in the coming years. The main risk is faster-than-expected appreciation of the CNY, which could dent the appetite of Chinese investors for stocks listed overseas due to currency translation losses they would incur.

Important drivers

Fixed income investors also need to adapt to the new era of higher inflation and volatility as this is likely to undermine returns from government bonds. We continue to view bonds as core to investors’ holdings, indicating they should have an allocation similar to that of the benchmark. Our preferred segment within the bond market is Emerging Market US dollar and local currency bonds. Factors supporting these bonds include a wide yield premium over US Treasuries that offer a cushion in an environment from rising yields. The recovery in commodity prices are important drivers of Emerging Market US dollar bonds, while a weaker US dollar is positive for local currency bonds.

Looking ahead, investors need to be prepared for the new ‘reflation’ era. While returns for global equities have historically been positive from current valuations as have returns from Emerging Market bonds, our preferred segment among fixed income assets, investors have to gird up for increased volatility.

— Clive McDonnell is Head of Equity Strategy at Standard Chartered Private Bank.