MARKET FOCUS

MARKET FOCUS


 
Embrace The Volatility
Best To Be Diversified In International Equities
21 November 2018
 
Local investors felt the benefit of shifting from a purely peso investment portfolio to a multi-currency portfolio after the peso depreciated 5.3% year-to-date (see Fig. 1). To make matters worse, we expect the peso to depreciate at least 3.0% per annum as the economy experiences the twin deficit problem — a rising current account deficit and an expanding budget deficit. Despite the recent heightened volatility (the VIX hit a high of 37 year-to-date), we still believe US equities offer more upside potential tactically relative to their global peers given the strength of the underlying economy. However, we encourage investors looking for international equity exposure to avoid pure plays and instead opt for a more diversified global equity portfolio. The S&P 500’s current valuation is stretched, trading at a 5% premium to its 10-year forward-PER average (17.7x) which will render it vulnerable to profit taking and more volatility in the foreseeable future.
 
Figure 1. USDPHP exchange rate
 
The US economy is surging. The US economy is expected to grow 2.5% in 2019, slower than 2018’s 2.9% growth. However, this is coming off a high base marked by S&P 500 corporate earnings expanding 16% yy in 2018 (excluding tax benefits). Based on 82% of the S&P 500’s market capitalization that have reported 3Q18 earnings year-to-date, 73% of companies have surpassed bottom-line estimates by an average of 6.4%. Moreover, the labour market is expected to remain tight (if not tighten further) given that the economy continues to add 213K jobs per month (see Fig.2). The average unemployment rate in the last three months stood at 3.8%, a rate not seen since 1999/2000. Similarly, average hourly earnings growth rose to 3.1% yy and the labor force participation rate inched higher to 62.9% in October (vs. 62.7% in September).
 
Figure 2. US GDP vs US Non-farm payroll
 
Be wary of rising bond yields. The rise in volatility in the S&P 500 is attributable to the Federal Reserve’s (Fed) indication to raise the Fed funds rate above what it deems the neutral rate (2.75%-3.00%). This effectively implies up to four (4) more 25bps rate hikes from the FOMC in the next 12 months, followed by a pause (see Fig. 3). Rising bond yields until recently signaled increasing confidence from the Fed that the economic recovery has finally gained momentum. But after the Fed raised its benchmark rate for the 8th time (since 2015) last September 2018, investors have become warier of further rate hikes. In fact, many see further rate increases as a step closer to slower economic growth and possibly a recession. There is no doubt that President Trump will be under greater scrutiny after the Democrats regained control of Congress, rendering Washington less able to pass legislation. However, we don’t see a divided Washington deterring the Fed from its current tightening path, which implies that we could still expect more volatility for the S&P 500.
 
Figure 3. US Treasury Yield Curve
 
The case for EM rises with lower oil prices. The price of oil has fallen by as much as 20% from four-year highs after the Trump administration’s recent decision to issue waivers to eight countries (including China, South Korea, India, Japan) allowing continued purchases of Iranian oil for a six-month period (see Fig. 4). Lower oil prices will continue to give relief to EM Asia currencies as the market discounts the potential improvement in their respective balance of trade. All told, the combination of compelling valuation (EM Asia now trading at 10.4x forward-PER or 11% discount from its 10-year mean), a resurgent local currency, and resilient earnings growth picture in 2019 (11.8% eps yy 2019 vs 14.3% yy eps 2018) should prove too much to resist for investors who are currently heavily underweight Asia.
 
Figure 4. Historical Oil Prices
 
Improved EM prospects will favour EU equities. Reported earnings for 3Q18 have been underwhelming thus far, on track to report +8.4% yy for 2018 (vs. +12.2% yy for 2017) due to lower trade receipts. But consensus estimates place EU companies posting stronger EPS growth in 2019 to +10.0% yy (vs. +8.4% yy 2018) despite the weakness in 3Q18 (see Fig. 5). Any recovery in EM next year and any relief in the US-China trade war issue will be more beneficial to EU given that 30% of export receipts are derived from EM (vs. only 15% for the US). Moreover, with US real GDP growth rate expected to slow to +1.8%yy in 2020 (vs. +2.5% 2019), Fed tightening is expected to pause. This should help narrow the US/Bund interest rate differential across the yield curve, which currently is at levels not seen since the late 1980’s.
 
Figure 5. Stoxx Europe 600 Index
 
Improved economic prospects for EM in the next 12 months are deemed favourable for EM/EU equities alike. The culmination of lower oil prices, de-escalation of trade tensions between the US and China, and a possible extended pause in the Fed’s hiking activities are seen to weaken the USD and favour EM. We encourage investors to diversify into international equities through the BPI Global Equity Fund of Funds to reduce the volatility in their portfolios (see Fig. 6).
 
Figure 6. BPI Global Equity Fund-of-Funds
 
 
 
Contributor:

Carlos A. Jalandoni
VP, AMTC Head of Research
BPI Asset Management & Trust Corporation
cajalandoni@bpi.com.ph

 
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Next Fed Chair Is Big News There is only one safe choice
Selection for next Fed Chair is huge.
26 October 2017
 
Who will replace Federal Reserve Chairperson (Fed Chair) Janet Yellen will determine the course of markets for the rest of 2017. Yellen’s term as Fed Chair will end in January 2018; President Trump has indicated that he will announce a replacement as early as 2Nov2017. Global markets wait with bated anticipation if Yellen will be extended or be replaced by somebody hawkish—one who advocates a much faster upward trajectory for interest rates. A more hawkish Fed Chair would not only drive interest rates higher more quickly, but could also result in a much stronger USD. Recall that the PSEi declined 20% in the 2H2016 due to the renewed strength in the USD coming from the Trump reflation trade.

The short list. President Trump has four top candidates: Kevin Warsh, Jerome Powell, Janet Yellen and John Taylor. Among them, Taylor is the most hawkish, believing that interest rates today should be at 2.5%, twice the current level of 1.25%; while Yellen is the most dovish—advocating slower rate hikes. Meanwhile, Warsh’s lack of experience renders him less likely to assume the position. The current front-runner, Powell, is seen as a soft spoken centrist who represents continuity like Yellen.

Trump’s agenda matters. Investors have so far ignored the potential disruption a more hawkish Fed Chair would bring to markets; the S&P 500 (2,575.21) and Dow (23,328.63) eking out new highs last week highlighted this. This is not surprising: investors believe their agenda is in-line with Trump’s goals. As much as conservative Republicans want a change from Yellen, we believe the Trump Administration prefers a continuity of current monetary conditions as it is favorable to wealth creation. The combination of a weaker USD and low interest rates has also boosted US corporate profits (+12% YoY 2018), underpinning the recent rerating in US equities.

Yellen again. We believe it is in the best interest of the economy (and markets) that Yellen is reappointed. While the economy is clearly on the path to recovery, it remains fragile as highlighted by the stubbornly low inflation rate. This is crucial since the biggest criticism of Yellen’s dovish era is the risk of being behind the curve—or not having high enough interest rates—which could lead to runaway inflation. But this is more manageable compared to Taylor. The risk here is destabilizing the economic recovery by raising rates too quickly. Recent history has shown that it is always easier to slow an overheating economy than it is to reinvigorate a slowly growing one.
 
 
Contributor:

Carlos A. Jalandoni
VP, AMTC Head of Research
BPI Asset Management & Trust Corporation
cajalandoni@bpi.com.ph

 
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