How to invest in a late-cycle environment

This bull market is approaching a decade of age and is now the longest on record since the 1930s.

• The writer is head of investment strategy, Bank of Singapore.

As we approach the fourth quarter of 2018 and beyond, many investors are increasingly cognisant that we are venturing deeper into the late stages of the global economic cycle, but navigating the cross-currents of the late-cycle market ahead can be confusing.

On the one hand, global economic and earnings growth remains positive, the labour market continues to look healthy, and the risk of a recession over the next 12 months is quite low.

On the other hand, however, history shows the hand-off from monetary accommodation to normalisation - during which central banks begin to raise interest rates - can be a tricky affair.

From those attempting to make sense of the markets ahead, one adage often heard is that bull markets do not die of old age but of exuberance.

The common wisdom this imparts is that, considering the lack of animal spirits today, this bull market will inexorably continue - until it hits a feverish pitch before suffering a precipitous crash.

We caution that this boom-and-bust framework is overly narrow, and those investors waiting for a raging bull market or a wipe-out crash may both be disappointed.

Their investment portfolios could also be poorly positioned for what lies ahead.

Without excessive asset mispricing as we head into the late cycle, instead of boom-and-bust, it is more likely that we will see a broadly challenging environment for investment returns characterised by lower returns, higher volatility, but a limited scope for a very deep market crash.

In this late-cycle backdrop, it is important for investors to be diversified and engaged, and be more nimble for opportunities thrown up by a volatile market.

One such area of opportunity today is emerging market high-yield bonds, which have suffered one of their worst year-to-date performances in recent history.

At current prices, however, we see positive risk-reward and believe that the combination of attractive valuations, firm bottom-up fundamentals and adequate economic growth will outweigh prevailing headwinds over the longer term.

One major reason for the price weakness was a rapid spike in rates in the first half of this year, during which the 10-year US Treasury yield rose from 2.4 per cent to a high of 3.1 per cent in only five months due to fears over rising inflation.

We see this to be less of a headwind ahead, and expect rates to rise in a more orderly fashion over the next 12 months as markets reflect increased comfort with the trajectory of rates and inflation.

In addition, while a strong US dollar could remain as a headwind over the near to mid term , we note that current account positions across the emerging market universe have generally strengthened since the taper tantrum in 2013, and emerging market currency valuations at current levels are broadly in line with their fundamentals.

Investors with exposure to emerging market high-yield bonds should ensure that they are effectively diversified. Because the deep emerging-market universe comprises disparate countries in different geographic regions - with idiosyncratic risks embedded in specific economies and corporates - portfolio diversification is important for achieving meaningful returns in line with the asset class as a whole.

Another area of opportunity is Asian equities, which have recently declined to levels where value is emerging. Sino-US trade tensions are seen to exert a heavier toll on Asian economies, which are more dependent on trade, and the recent divergence in performance between US and Asian equities has been stark. We see several signposts, however, that signal positive risk-reward at current prices.

First, Chinese policy easing has gained speed recently. The Chinese authorities have significant dry powder in their policy arsenal to offset the hit from trade by boosting domestic consumption and, over the last few months, we have seen them implement fiscal support, and ease monetary policy by lowering interest rates and reserve requirements - and we believe more will be done if needed.

The second signpost is the Chinese yuan. After a period of benign neglect, Chinese policymakers are growing more concerned about the weakening of their currency towards the 7.0 level against the US dollar. We see an eventual stabilisation of the yuan as the Chinese government is not incentivised to see excessive declines from here. This will be supportive of Asian equity markets.

Finally, valuations have turned more attractive for Asian equities alongside the China stock market, which has declined by more than 20 per cent since its January peak. Many Asian stocks with solid fundamentals and sound long-term outlooks have become more compelling at current levels.

Source: The Sunday Times © Singapore Press Holdings Limited. Permission required for reproduction

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