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Wednesday, 12 January 2011

Bulls likely to run on this year

But there will be periodic bouts of risk aversion triggered by the euro area sovereign debt crisis


THE bull market in risky assets that started early 2009 will likely survive the coming year, notwithstanding the current weakness in equities. Equity bull markets typically do not terminate after only 20-21 months. Three years is the average length of bull markets since World War II, with more recent equities rallies lasting longer. The end of bull markets is usually associated with recessions, overvaluation, high cost of funds, or financial crises - or a combination of the above.

There is no recession in sight. Not in the United States where the steepness of the Treasury yield curve suggests that there is only negligible probability of a double dip over the course of 2011, and certainly not in Asia ex-Japan.

Equity valuations in most markets remain modest, trading in the lower half of their cyclical ranges. The price gains over the past two years have been driven to a very large extent by earnings recovery rather than valuation multiples expansion. Even in Asia ex-Japan, despite massive outperformance, stock valuations are 'mid-cycle' rather than 'late cycle'. And the yield gap in the US - that is, higher equities earnings yields relative to investment grade bond yields - is larger than at any time over the past decade, suggesting that stocks are cheap relative to fixed income. The gap is even more glaring for equities earnings yield relative to US government bond yields (see Figure 1).

Yes, rates are going up in Asia ex-Japan. And there is a possibility of the US Federal Reserve hiking rates towards end-2011. But those hikes are off ultra low bases. And the power of zero - that is, zero or near zero interest rates in many parts of the world, including the US, Japan, Singapore and Hong Kong - remains a powerful driver of investor behaviour. The choice is stark: Stay invested or face zero to negative real returns for cash.

Nevertheless, investors should moderate their expectations. This is a bull market approaching the end of its second year. Gains will be harder fought. There will be periodic bouts of risk aversion triggered by the euro area sovereign debt crisis. This leads us to the risk of the bull market being derailed by financial crisis - the most credible of the threats outlined above. The euro area sovereign debt problem could unfold in an erratic manner over the course of 2011. The market understands the vulnerabilities.

Ireland and Greece run government budget deficits of around 13-14 per cent of gross domestic product (GDP). They are around 11 per cent for Spain and 10 per cent for Portugal. As a result of this overspending, their governments have run up huge debts. Further, these economies rely on external financing, so they are subject to the harsh discipline of international markets. In financial markets, sentiment can become reality. If the markets aggressively sell down your debt, it drives up borrowing costs. And if governments are already overspending their budgets, sharply higher borrowing costs can only further undermine fiscal credibility. Yet, if they cut spending too deeply, they will shrink their economies and tax bases. Once economies are caught in the downward spiral of ballooning debts, sharply higher interest charges and shrinking economies, the line between illiquidity and insolvency becomes a very thin one.

This is a tough call. But the euro area sovereign debt crisis is unlikely to spiral into a global, systemic crisis as with Lehman Brothers. The European Union (EU), International Monetary Fund (IMF) and the European Central Bank (ECB) understand that the stakes are high. They understand the impact of sovereign debt defaults on the European banking system. They have little choice but to buy the sovereign debt of the PIGS (Portugal, Ireland, Greece and Spain). Indeed, the ECB has yet to really stretch itself in bailing out PIGS sovereign debt.

These debts are denominated in euros. So if pushed into a corner, the ECB could print euros to monetise the debt. So far, the ECB has shunned quantitative easing, choosing to sterilise their purchases of PIGS sovereign debt. Yes, the euro would be aggressively sold down if the ECB embarked on quantitative easing. But economically, that may not be a bad thing for the euro area as debt crises typically require massive currency devaluation to restore competitiveness.

While the euro area is struggling with debt deflation, Asia ex-Japan has to deal with the threat of inflation. The story for Asia ex-Japan equities is one of divergence told in three chapters. The first chapter has already played out. In the early stages of the global economic recovery, Asia ex-Japan diverged from the West with earlier and more robust economic rebounds. Our markets were rewarded with large capital gains, with some approaching or even exceeding 100 per cent recovery of the losses from the peaks of 2007.

The second chapter is currently being played out. The strength of Asian ex-Japan economies is now restraining our equities markets. While the US remains in quantitative easing, Asia ex-Japan has gone into policy tightening mode. The fear now is of rising inflation and higher interest rates.

But the final chapter, which is likely to be played out later in 2011, should see Asian ex-Japan equities again being rewarded for their superior economic fundamentals. Before year-end, the markets are likely to look ahead - past the rate hiking cycle in the region - towards still resilient growth and superior fundamentals.

Commodities are likely to push higher through the course of the year, possibly even outperforming equities. Asia ex-Japan equities are struggling sideways to weaker because of the fear of interest rate hikes. But those interest rate hikes are the result of robust economies. And strong economies drive growth in consumption of commodities. Investors should continue accumulating commodities as China 'plays' and as hedges against higher US inflation one to two years down the line.

Gold, having doubled over the past 26 months, is likely to continue correcting in 1Q-11. But the correction is likely to be shallow given the likelihood of a multi-year decline in the value of the US dollar. Gold has very low correlations against other asset classes. Investors should consider gold on the dips as a diversifier in their portfolios and as a US dollar hedge.

The US dollar could continue to strengthen against the euro in the early months of 2011 - on both euro area sovereign debt fears and rising US Treasury yields. But beyond that, the US dollar is likely to weaken again on quantitative easing. Asia ex-Japan currencies should make further, moderate gains against the US dollar over the course of 2011 on the back of its stronger economies.

For the coming quarter, I would keep a neutral weight for equities, underweight bonds in view of rising yields, and overweight alternatives, particularly commodities. Within equities, I would put Asia ex-Japan on neutral weighting and overweight US equities on continued economic recovery in the face of quantitative easing and near zero interest rates.

The writer is the chief investment officer for DBS Bank

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