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MORE volatility expected in near term

Six year ago, on Sept 15, Lehman Brothers was declared bankrupt, sending shockwaves across the globe.

Setting aside the question of whether the global economy has recovered from the 2008 financial crisis, the equity markets, particularly Wall Streets and Asia, have fared well since then.

On Sept 18 (Thursday), the Dow Jones Industrial Average headed to a record high of 17,265.99 points, soaring 51.6% since September 2008, while the S&P 500 is currently trading at 2,011.36 points — its highest ever — up 60% in the past six years.

Thanks to quantitive easing (QE) policies, the influx of foreign capital has fuelled a strong rally in emerging markets, including the Asia Pacific, lifting share prices to historical high levels.

But QE, a remedy for the crisis, will end in October. This is not news to the equity markets. However, uncertainties have arisen on the horizon that point to a more bearish outlook, including rising geopolitical risks, global economic health, lacklustre corporate earnings and impending interest rate hikes.

“There are many commentators out there who predict an imminent end to the bull run in the US market. [But] calling the end to any bull run is extremely difficult. In an environment such as the current [one] — where inflationary pressures are absent, central banks continue to maintain loose monetary policies and with the major central banks of Japan and Europe embarking on quantitative easing of some sort —  the markets can thrive for longer than expected,” Hwang Investment Management Bhd’s Chief Investment Officer David Ng tells The Edge.

He says that at present, equities as an asset class continue to look relatively cheap compared to bonds. Nonetheless, he would not rule out a short-term correction soon because volatility has begun to pick up in bond and foreign exchange markets of late.

“However, to call an end to the uptrend is still premature in my view,” he says.

Taking cues from interest rates

Several fund managers believe that other than geopolitical risk, the timing of an interest rate hike in the US is something to watch closely as it could trigger a correction. When Wall Street sneezes, the world markets catch a cold.

A hike in the first half of next year would likely be seen as negative by the market, but an increase in 2H2015 would be more palatable, according to them.

BNP Paribas Director and Head of Asean Equities Patrick Chang shares this view, but notes that any possible correction would likely be shallow.

“If data in the US supports the view that interest rates in the country will have to be raised sooner rather than later, then that could be a potential trigger. But to put things into perspective, this is the most talked-about topic this year, and yet long-term bond yields in the US are down and equity markets globally are up. So, I’m hopeful this event risk could be partially priced in and we move on to focus on growth,” says Chang, who does not expect higher interest rates in the US to be disruptive to equities.

US interest rates have been held at a near-zero 0.25% since the global financial crisis began in 2008, in an effort to stoke growth. At the moment, inflation in the US remains within the 2% range that the US Federal Reserve is comfortable with. Looking ahead, the futures markets suggest that the market is pricing in a 50bps hike in the target rate to 0.75%.

“The Fed has an exit strategy of two parts. It wants to normalise interest rates and it wants to shrink its balance sheet. The challenge with normalising interest rates is that the economy is too fragile to hike rates for the foreseeable future. Higher interest rates would also be very challenging for the government as interest expense could double or triple quickly with modest rate hikes,” says Robert Levitt, founder and chief investment officer of US-based Levitt Capital Management.

“The Fed also understands that QE is causing a concentration of income and creating unrealistic markets — the opposite of free markets.  So, the Fed will try to manage higher rates by raising them very gradually,” he explains.

Expectations at home

On the home front, the FBM KLCI has climbed 80% since September 2008, outperforming the Dow.

Concerns of a steep correction have also extended to the local bourse, amid expectation of weaker economic and corporate earnings growth.  
This year, the benchmark has gained slightly less than 1%, while the FBM Small Cap Index rose 21.15% this year.

“We have been cautious on the Malaysian market for the most part of this year, being underweight the market. This is on the back of very muted earnings growth of 1.4%, which does not support its high valuations of 16.7 times current year. I would be even more cautious on the small caps, as the FBM Small Cap has risen by 20% this year and values are currently not compelling —  12.7 times against 9.5 times historically,” notes Chang.

On the other hand, Ng points out, “The absolute levels of an index are not always a good measure of whether the market will rise or correct.  One must look at the valuations. Based on historical ranges, the Malaysian market is trading above its long-term average, but not by much. However, there seems to be a disconnect between the macro economy [where GDP growth has been strong] and corporate earnings [which are weak].”

Nonetheless, Ng shares Chang’s concern about the exuberance in small caps.

Going ahead, fund managers expect any substantial correction in the US market will resonate in other markets, even our own, due to the interconnectedness of the monetary systems in the short term. However, based on past experiences, Malaysian equities tend to be more insulated from volatility due to their defensive nature.

Ng points out that Malaysian equities are underpinned by large domestic liquidity while the practice of shorting stocks is not prevalent. Futhermore foreign shareholding levels in the Malaysian market are at the lower end of historical normal ranges, hence foreign selling pressure would be more muted.

In the meantime, Etiqa’s Chief Investment Officer Chris Eng expects to see the market trading sideways in the short term. However, he expects to see the FBM KLCI breach the 1,900 mark by year-end.

What the fund managers are doing.

“In my heart I am bearish, but in my portfolio I am neutral. The explanation is that I expect short-term turmoil, but over the long term, I am quite positive, especially with economies like Malaysia and Indonesia,” says US-based Levitt.

“Markets rarely fall from record highs straight down.  And markets tend to climb a wall of worry.  The key since mid-2011 has been to buy what you know has staying power. Buy what you wouldn’t mind owning for several years, no matter what happens in the economy. Stocks that wouldn’t go bankrupt if the economy endures several years of decline. There are markets where I would be willing to add money to more speculative stocks, such as Indonesia, which is undergoing a fundamental transformation in governmental policies. In Indonesia, I have been buying small cap stocks,” he says.

Notably, the US dollar has been strengthening against most other currencies, which can be negative for emerging markets. However, Levitt points out that it does help one market, Japan, where he has a long position. At the same time, he is cautious about China, due to the slow growth in its largest trading partner, Europe.

Meanwhile, Ng advises investors to return to the basics of investing, identifying companies with good management, healthy financials and the ability to continue to grow their earnings.

“There is no denying that the universe of such companies is getting smaller and this is reflected by the above-average multiples of the market in aggregate, but such companies can still be found,” he says.

Eng notes there is still opportunity in stocks such as Tenaga Nastional Bhd, select oil and gas players like Dialog Group Bhd and Bumi Armada Bhd, as well as long-term consumer companies with a strong track record. Beneficiaries of the Malaysian Airline System restructuring such as AirAsia and AirAsiaX, will also present value, he says.

“Invest in solid fundamental stocks, with an eye to exit by January 2015,” Eng advises investors.

Meanwhile, Chang recommends investors to “lock in profits from local small-cap counters and buy the dips in Asean markets like Vietnam, Indonesia and Thailand, which we think will continue to be re-rated.

This article first appeared in The Edge Malaysia Weekly, on September 22-28, 2014.

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