A repricing of risk

Equity markets remained volatile after the turbulence last week, which saw both the S&P 500 and Dow Jones Index slip below their 200-day moving averages. This episode, in our view, is akin to an air pocket which investors will experience in a bull market.

The move up in US long term rates seemed to have caused the initial unease. The US 10-year Treasury bond yield rose to 3.2% - a level last seen before the Eurozone debt crisis seven years ago. Yet, it was just last month when investors had fretted over the flatness of the US treasury yield curve and the recessionary warnings arising from an inverted curve.

Nevertheless, investors moved to protect profits and asked questions later. Some of the sectors and strategies which came under heavy selling pressure included the FAANGs which has outperformed year to date. Momentum and growth-oriented stocks also corrected. The spike in market volatility also forced volatility targeting and risk parity strategies to reduce their exposures, exacerbating the sell-off.

The yield curve is normalising as the Federal Reserve (Fed) embarks on a gradual hiking path, supported by the strength of the US recovery. Despite robust US labour market reports, inflation is likely to remain benign. While the US unemployment rate fell to 3.7% in September, its lowest level since 1969, further analysis suggests that the jobs picture may be less rosy than it appears.

Figure 1 shows that the jobs recovery looks to be dominated by those aged 55 years old and above. In addition, the participation rate seems to have plateaued in Figure 2. As such, the unemployment rate could have fallen partly because job seekers are leaving the workforce. Investors may not need to be overly concerned about rising wages and a quicker than expected pace of rate hikes for now.

Fig 1: "Baby boomers" dominate the US jobs recovery

Source: Eastspring Investments. Datastream. October 2018. Unemployment rates are indexed at 100 from 2008.

Fig 2: A low participation rate suggests that many have dropped out of the work force

Source: Eastspring Investments. Datastream. October 2018.

The latest US inflation reading supports this view – US consumer prices grew 2.3% year on year in September, well below market expectations. As higher interest rates temper US house prices, the largest component of core CPI, US inflation is unlikely to run away anytime soon.

While inflation remains benign and US financial conditions are still supportive of growth, we are not complacent. The third quarter US earnings season has kicked off and the consensus expects earnings growth of 19.2%. Any hints from management that US-China trade tensions may affect future activity could trigger further market volatility. While we acknowledge that US earnings revisions are going negative in the US, management tends to guide down earnings in order to beat expectations. The jury is still out.

According to data from S&P and Bloomberg, less than 50% of the buyback announcements made by S&P 500 companies in the second quarter has been executed. A rise in buy back activity in the months ahead could support markets but also contribute to a modest funding squeeze into the year end.

At the same time, rising oil and gasoline prices could weigh on growth by reducing consumer spending, while boosting inflation. With gasoline pump prices rising towards USD3 a gallon, the US administration is likely to be watchful ahead of the mid-term elections in November. If the sanctions on Iran disrupt oil supply as the global economy continues to grow, this could drive oil prices higher, at least in the short term. Faced with such an outcome, the Fed may increase rates to contain inflation and slow growth or conversely cut rates to support growth and let inflation pressures mount.

Regardless of the path taken, investors may demand a higher risk premium as the risk of policy error rises. The dollar could remain firm in both scenarios

Investors can take advantage of the opportunities that arise from the short-term knee jerk reactions to higher Treasury yields. From a multi asset perspective, US and Asian high yield bonds offer attractive yield pickups and compelling valuations respectively. The Indonesian rupiah should ultimately be supported. A proactive Indonesian central bank has raised interest rates and delayed non-priority infrastructure projects to stabilise its current account. Fundamentals are also stronger with short term external debt accounting for only 16% of total external debt. Overall, higher government bond yields globally provide attractive entry points for investors to add important defensive exposures to their portfolios in view of the rising volatility.

Markets are likely to remain choppy in the near term as higher yields prompt investors to reassess their portfolios. However, the repricing that takes place will re-assert the different roles traditionally played by equities and bonds in investor portfolios, re-affirming the appeal of multi asset portfolios.