New Federal Reserve Chairman Jerome Powell’s first day on the job saw him take up the post following an unexpected pick-up in US wage data in January. By the time he left the office that day, US bourses had suffered their sharpest sell-downs in more than a year. Major markets in both the US and around the world would slide lower over the rest of Powell’s first week, erasing 2018’s year-to-date gains.
The trigger came as January’s non-farm payroll increased by 2.9%, suggesting that labour-market tightness and rising energy prices are feeding into higher inflationary pressures, creating speculation that the new Fed chair may need to accelerate the central bank’s tightening pace. These concerns weighed on bond prices, with January’s inflation data of 2.1%, pushing 10-year yields above 2.9%, the highest in four years. Coupled with an improving global backdrop, anxieties surfaced that perhaps other central banks may also need to raise borrowing costs more aggressively than guided, in turn weighing on equities and risk appetite.
The correction was justified in our view, given that the rally had not experienced a significant daily sell-down for quite some time. Removing short volatility positions should help improve market dynamics, as believing that markets would remain calm indirectly suggests a risk-free environment – an investment sin. With 2018 stock gains having been wiped out by mid-February, Asian markets welcomed the New Year, as investors welcome a new start on any calendar. With 2018 being the Year of the Dog, investors are also hoping that the market’s recent bark is louder than its bite, perhaps repeating the 2013 “taper tantrum”, when expectations of a pullback in the Fed’s quantitative easing programme proved tougher than the actual tapering.
But whether investors think about the calendar year or Chinese New Year, it is important to grasp that removing short volatility trades is not synonymous with removing risk. Some of 2017’s biggest geopolitical concerns have been placated but they could reappear later. A symbolic unification between North and South Korea during the Winter Olympic Games has calmed some of the bellicose rhetoric, but uncertainty persists and it remains to be seen whether the détente between the Korean neighbours will continue after the closing ceremony. European elections continue to bear witness to popular sentiment, while protectionist threats are mirroring instability within a capricious White House. Should changes in the US labour market lift wages further, inflationary concerns could instigate higher long yields. The combination of higher labour costs and debt servicing is weighing on corporate earnings and profitability outlooks, which are clawing back some of the benefits from the recent tax cuts. By their very nature, these lift volatility, particularly as markets looks for a new fair value in bond yields that reflects the current economic cycle, which now includes fiscal stimuli in the US.
Removing complacency and injecting risk is positive in the long run, particularly for active fund managers, as evidenced by the concentration within sectors and stocks during the sell-off. In this environment, Asian equities still remain attractive, given reasonable earnings projections and valuations that are discounted compared with developed markets, as well as geographic diversification, that is often forgotten among investors. This is most pronounced in Asia’s South-East Asian markets, where, despite MSCI’s ASEAN +26.3% return in 2017, they had underperformed and were overshadowed by MSCI’s Asia ex Japan’s +38.7%, which was primarily driven by Chinese equities.
Given the proliferation of domestic demand and sector diversification, Asia should prove relatively resilient if volatility remains on the periphery. But while Asia’s larger economies followed world indexes lower and returned year-to-date gains, ASEAN remained in positive territory. ASEAN’s historical struggles against higher US interest rates and a stronger US dollar have faded due to maturation of local debt markets, which avoid the asset and liability currency mismatches that aggravated the 1997 Asian financial crisis.
ASEAN has maintained positive real rates for several years, as currency appreciation over this period can absorb a sudden US dollar rally should cyclical growth surprise on the upside. Much of ASEAN’s economic ammunition is derived from previous global deflationary pressures, as an inelastic supply curve allowed consumers to absorb lower input prices, which essentially became an income transfer to households. In our view, a sudden surge in oil would be the biggest risk to ASEAN rather than a monetary policy miscalculation.
ASEAN complements our constructive view on Asian equities, as volatility could close the underperformance of South-East Asian markets against regional peers. As risk returned mid-month, investors used the bull market correction to pick up 2017 outperformers, a practical response, since synchronised global growth remains evident in the current cycle. Ultimately, an inflation recovery serves as the transmission mechanism that converts elevated sentiment and confidence into a renewed capex cycle, extending optimism in our outlook. But this path is neither linear nor straight, suggesting that volatility becomes a meaningful variable. For the upcoming Lunar New Year, let us hope no one ends up in the dog house.
Fund Manager - Asia