Investing in a reflationary environment


Manpreet: ‘We are entering the year with equities as our most preferred asset class.’

RECENTLY StarBizWeek caught up with Manpreet Gill, head of fixed income, currencies and commodities (FICC) investment strategy at Standard Chartered Bank.

He tells how investors should position themselves in a reflationary environment, why oil prices will trade at the US$60 to US$65 level, and why he still favours the US equity market.

He is a key member of the bank’s group investment council and also acts as an advisor to the discretionary portfolio management division. Manpreet has significant experience in financial markets: his previous roles have included Asia strategist at Barclays Wealth in Singapore and G10 FX strategist at ICICI Bank in India.

He holds an MBA from INSEAD, a MA in Economics from the Delhi School of Economics and a BA in Economics from St Stephen’s College.

While Manpreet is now based in Singapore, he has previously lived in a number of countries in Asia, the Middle-East, Africa and Europe. He is an ardent motorsport fan.

Below are excerpts of the interview.

What is your outlook for the equity markets this year? Let’s start with the US, followed by what you think about China and emerging markets?

We are entering 2017 with equities as our most preferred asset class. From a macro perspective, we believe the global environment is turning increasing “reflationary” (meaning growth is better and it’s coupled with higher inflation) after years of muddling through, which should be supportive for growth and earnings.

Within this, of course, regional and sector preferences are important. From a regional perspective, the US is our most preferred equity market. A lot of this comes down to earnings and policy. After many quarters of contracting earnings, an energy price rebound means earnings growth should turn firmly positive over the coming quarters. We also expect this to be reasonably broad based and not driven by the energy sector alone. Policy is also key – earnings expectations for 2017 may already be reasonably high, but should Trump follow through with his proposed corporate tax cuts, earnings expectations could yet be revised higher.

Market damper: Novelty licence plates for sale in front of the New York Stock Exchange in New York recently. Wall Street stocks retreated early Jan 30, joining other major markets that have fallen after President Donald Trump’s controversial ban on people from seven predominantly Muslim countries entering the United States. – AFP
Market damper: Novelty licence plates for sale in front of the New York Stock Exchange in New York recently. Wall Street stocks retreated early Jan 30, joining other major markets that have fallen after President Donald Trump’s controversial ban on people from seven predominantly Muslim countries entering the United States. – AFP

What do you think about the Japanese and Asian markets?

Japanese equities are a second preferred area, on a forex hedged basis. The main driver of this view remains the currency – despite policy efforts thus far, Japanese equities have maintained their tight correlation with the US Dollar/Japanese Yen exchange rate. Given our view yields are likely to rise in the US, but stay capped in Japan.

Within Asia, our preference lies within two relatively domestic-oriented markets – India and Indonesia. Outside of their long-term positive structural growth outlook, their relatively greater dependence on domestic economic growth, falling interest rates and continued reform efforts are key drivers of our view.

Are you concerned about China?

We are more neutral on Chinese and believe sector selection is key here. We believe the opportunity sits in ‘New China’ equities – for instance, not traditional state-owned enterprises, which tend to be a significant sector in traditional equity market indices, but sectors focused on domestic consumption and services. These would include China software and services, healthcare, consumer and telecom services sectors.

On the risks side, the single biggest factor we will be monitoring is whether, and how, our expected pivot towards a more reflationary environment is panning out. Specifically, this means keeping a tight watch on inflation – moderately higher inflation is good for equity markets, but very high inflation can be detrimental – and whether growth and policies to support growth are able to offer the earnings support needed for our thesis to play out.

Valuations wise, the US market is expensive. Do you foresee the good economic growth sustaining the Dow and S&P?

US equity market valuations are admittedly above their long-term average. However, we do not believe this should be a concern on its own because firstly, valuations can be a good indicator of multi-year returns, but are less useful on shorter time horizons, especially less than a year.

Secondly, valuations are not yet at extremes that point to a potential reversal. It is also worth noting that valuations rarely spend time around ‘average’ levels; usually, they are either well below or well above this average.

More importantly, our focus is on whether key drivers are supportive of markets growing into their valuations. We believe earnings will be particularly important – while multiple expansion has been a key driver of markets over the past few years, earnings growth will likely have to take the baton from here; good news on this front can justify current valuations. Other factors we think are likely to offer support to valuations include the potential for corporate tax cuts, share buybacks and dividend payouts.

Are stocks expensive or cheap?

At a global level, there is a valuation divide between developed and emerging equity markets. Generally speaking, developed markets are much more fully valued while emerging markets are much more inexpensively valued. Having said that, there is quite a bit of divergence within this, particularly in emerging markets where there is a great deal of dispersion across countries and regions.

For us, valuations are an important part of any long-term investment decision, but it is far from being the only major factor. We believe valuations need to be balanced against other major market drivers like the earnings outlook, interest rates, fiscal policy, currencies and flows. As much as it is tempting to gravitate towards markets that are cheap and away from markets that are expensive, we need to be equally cognizant of the risk that a cheap market can be a ‘value trap’ or an expensive one could not cheapen for a long period of time.

Based on what you just said, what would your investing strategy be like?

Our starting point is always a diversified investment allocation both within asset classes like equities, and across asset class such as bonds, equities, commodities and alternative strategies. We believe this is the most primary defence against uncertainty as well as ensuring exposure to positive surprises.

Given this context, we believe it is about focusing on what we see to be a rising pivot towards a reflationary environment, but holding some insurance-like assets against the risk we end up with either excessive inflation, or fall back into deflation. What this means in more tangible terms is that we would hold more equities than usual, with a focus on the US and Japan (forex-hedged) globally and India and Indonesia in Asia.

How about your bond strategy?

Within bonds, our basic approach is to rebalance away from sub-asset classes that are vulnerable to a continued rise in yields towards those that are less sensitive. This means rebalancing away from investment grade corporate in the US and Europe towards US high yield bonds and senior floating rate loans. Within Asian US dollar corporate bonds, though, we believe a focus on higher credit quality is more important. We also continue to like a multi-asset income approach because, while we expect US dollar yields to continue to rise, the absolute level of yields remains well below those that may create significant risks for this strategy.

We would also look to add oil-related exposure should prices pull back towards US$50 per barrel and, in currency markets, position for continued US dollar gains at least in the early part of the year.

Having said that, we believe this pivot-towards-reflation approach should be complemented with sufficient hedges against both upside and downside risks to inflation. One can make a case that a small allocation to gold has a role to play here; higher yields and a stronger US dollar are generally bad for gold, but gold could offer an attractive hedge against the risk inflation jumps by more than expected.

More generally, we believe a basket of alternative strategies offers attractive exposure; many sub-asset classes have historically demonstrated their value during periods of significant equity market corrections, for example.

Do you see investor interest in emerging markets picking up? Particularly since the currencies have been bashed down quite badly from last year.

We do, but selectively. There are a few factors favouring emerging markets at the moment.

Firstly, emerging market growth is accelerating relative to developed market growth for the first time in many years.

Secondly at a broad level, emerging market equity market valuations are more attractive than those in developed markets, and thirdly, many emerging markets, especially outside Asia, are emerging from recessions or experiencing sharp pullbacks in their equity, bond and currency markets. Other factors such as increased commodity price stability, greater reform efforts and stability in China are also positives for many individual emerging markets.

Are you worried that a strong US dollar would impact emerging markets?

Yes, there are counter-balancing factors. The most significant risk is that of rising interest rates in the US; historically, this has tended to be a challenging environment for many emerging markets as they could trigger capital outflows. Many export-oriented emerging markets could be at risk from an increasingly protectionist world. A rebound in oil prices or global inflation could be a challenge for some emerging markets by limiting room for further rate cuts or placing pressure on their currencies.

Hence we believe a selective approach, looking for the best rewards on offer for the risk taken, is a prudent approach. Within equities, we find Indian and Indonesian equities attractive for reasons discussed earlier. Within bonds, we believe a focus on higher quality within Asian US dollar bond markets is prudent. Within currencies, we believe US dollar/yuan is likely to continue to rise gradually, as in past years, but we expect the Indian rupee, rupiah, Brazilian real and Russian ruble to outperform other emerging market currencies.

What’s your view on the Malaysian market in particular?

We believe there is some justification to have an allocation to Malaysian equities. In our view, the reasonable yield on offer is a key driver of returns. However, we believe there are more attractive investment opportunities elsewhere as sector diversification in Malaysian equity markets is relatively limited compared to many other regional markets. The sector composition is also relatively concentrated in more defensive or palm oil-related sectors, which are at risk of underperformance in our reflationary outlook.

As a start, we would argue local bonds are at least as attractive given the similar (in some cases higher) yield on offer. More broadly, we see more attractive investment opportunities outside of Malaysian equities or other local assets. We have discussed our preferred equity markets elsewhere, but this also has the double benefits of raising diversification within equities, and also diversifying currency risk away from the ringgit alone.

How do you think oil prices will perform this year?

We remain constructive on oil prices and believe they should continue to trend higher towards US$60 to US$65 per barrel. Our view stems from a simple demand-supply view; suppliers are already producing close to their maximum outputs while demand continues to grow more rapidly than supply. This means the demand-supply gap should continue to close. The Opec agreement helped speed up this process, but the fundamental directional remains unchanged, in our view.

However, the reason we believe price gains are likely to be limited to US$60-US$65 per barrel is the potential for greater US shale oil supply at this price. Reports suggest this is the approximate price range at which much greater US shale oil supply would be willing to meet demand (because its cost thresholds would be crossed), suggesting this may end up being a natural limit to oil price gains for now. The key risk to our view, of course, is if US shale oil is successful in reducing costs below this level.

We do not expect prices to go up in a straight line. Given how oil prices have risen around the turn of the year, we would await any pullbacks towards US$50 per barrel in Brent oil before considering adding further to oil-related exposure.

How will the potential rate hikes in the US affect emerging markets? Has that been priced in?

As we discussed earlier, the main risk from potentially higher rates in the US is the risk of capital flight. Historically, periods of rising US interest rates have tended to coincide with capital outflows from emerging markets.

However, this is not a hard and fast rule. We believe there are three factors to keep in mind. First is that many emerging markets have already face significant capital outflows, which suggests the most susceptible components may already have left. Second is the absolute level of yields; unlikely many periods in history, the gap between low US rates today and what is often fairly high rates in many emerging markets is quite high. This may offer an additional source of support. Finally, US interest rates would most probably have to rise at a faster pace than what is already expected in order to trigger a fresh market response. Markets are arguably already looking for at least one rate hike from the Fed this year, so an upside surprise from this baseline would likely be needed in order for markets to worry.

Could there be such a situation where interest rates go up, but it is not detrimental to emerging market currencies?

There are a number of possible reasons why this could be the case. US interest rates could rise, but at a much slower pace than expected. This also means higher yielding emerging market currencies (like the rupee or rupiah) may be less vulnerable than lower yielding ones. Emerging market growth could continue to accelerate relative to developed market growth, which would underpin interest in equity exposure. Finally, the currencies may have already priced in a significant portion of the risks, leaving less room for further downside. The ringgit is a good example of this given just how much it has already weakened over the past few years.

What are some some the important trends you see taking place in the economy?

Stepping back and looking at the global economy, we believe there are interesting trends on both the growth and inflation side which we think are worth tracking and using to direct our choice of investment ideas.

On the growth side, we believe a greater shift towards fiscal spending in the US is likely to be positive for growth. Speed of implementation is the main risk given limitations on the number of “shovel-ready” projects, but directionally policy points to the upside.

More broadly, however, emerging market growth is likely to continue accelerating at a faster pace than developed markets. Much of this is led by emerging market economies outside Asia, especially those rebounding from a recession.

On the inflation side, we expect inflation to continue to rise in much of the developed world. This is most visible in the US where headline inflation continues to creep higher, though it is least likely in Japan which remains one economy where inflation continues to struggle to take hold.

In emerging markets, the picture is more mixed – in China, for example, producer prices are rising after a long period of contraction, pointing to higher inflation ahead, while in other economies inflation appears to be on a slowing trend.

More broadly, we tend to think in terms of ‘economic scenarios’ that incorporate much of these factors as a guide to choose investment ideas. For the last few years, our view has been that we have been in a “muddle-through” environment where growth and inflation muddle along despite numerous risks.

This year, however, we believe many of the trends described above point to a rising pivot towards reflation, characterised by both accelerating growth but rising inflation.


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