Global risk assets like fixed income and equities are being shaken violently this week as the risk premier are in the midst of been re-priced. Interest rate and volatility are hoarding the limelight in the current equities sell-off that started in late January before cascading into a technical correction of 10% for the S&P 500 on Friday, February 9. The benchmark 10-year treasury yield rose to near 2.85% interest on Friday. During the week, the yield reached a four-year high of 2.885% that had triggered Monday’s equity market sell-off globally. Volatility of equities, as measured by the Chicago Board Options Exchange (CBOE) Volatility Index known as VIX, spike up over 116% on Monday, the first time it happened since early 1990s. The VIX hit a high of 50.20, highest since 2011.
Are we in a systematic situation like a crisis or fundamental adjustment for asset prices? I like to think we are in the latter event as rising interest rate, the reference rate that all risky assets are being priced off, is on the uphill march. But if the sell-off worsens and over the coming weeks, affecting investors’ sentiment and confidence, it could very well developed into a systematic fallout with serious consequences.
The case I put up for fundamental asset adjustment is simply that higher interest rate will mean that future cash flows are lower when discounted to present day and equities and fixed income are priced off the streams of expected cash flows. Over the last few years when interest rates are low, U.S. equities valuation via Price-Earnings Ratio can justify over 18x. However, when interest rate normalises to 3 to 4%, equities can only fetch 14-15x on similar earnings growth outlook, implying a 20-30% price correction for the PER compression. The market is reacting to the spate of strong economic data that may likely spell the end of low inflation in U.S., following last Friday strong labour report. The Federal Reserve is likely hike interest rates by at least three times this year to ward off inflationary pressure, especially with tight employment in a late stage of the economic cycle and stimulated by the Trump administration tax cut. The days of the Goldilocks economy with benign inflation, cheap credits, and low volatility in the capital markets are certainly over.
Recommended Investment Strategy
Investors should take stock of their asset allocation and investment strategy. The days of passive investment in the new economic environment may not be effective as higher market volatility, coupled with higher cost of money, may require more active investment strategies. Also try to expand the allocation to other classes of assets as the current synchronize economic growth means demand for commodities and scare resources will be strong, underpinning expected returns that may easily beat those of equities over the next few years.
Emerging markets and European fixed income and equites are likely to outperform the U.S. equities and alternate investment classes like hedge funds and private equities are expected to do well. Our outlook for the USD against other major currencies remains bearish; it is likely to test 100 JPY, $1.28 vs EUR, $1.45 vs GBP before the end of this year as risk appetite wanes and other major central banks embark on their tightening cycle to tackle inflation. Lastly, we do not advocate buying the dip for the U.S. equities as the valuations of the S&P 500 is similar to the six major bear markets over the last century where the market lost almost half of its value over the course of a year after achieving their respective peak. The selling in the market is over when volatility falls back to the normal range of below 20 for the VIX. If investors are still keen on equities, healthcare & biotech, and consumer discretionary sectors offer rich pickings.
This article is written by Steven Koh (CFA), M.B.A (University of Chicago), M.Sc. (National University of Singapore) and is currently a fund manager at Overseas Chinese Investment Management.
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