Business Times - 07 Nov 2007MONEY MATTERS
Equities market bullish but dangerous
Heightened volatility is likely to be a constant companion as basic flaws in the US economy remain unresolved
By LIM SAY BOON
FOR the past 18 months, I have maintained my bullish equities stance in the face of three major corrections - the emerging markets meltdown, the Shanghai-led correction and the recent credit market crisis.
But with each 'survival' of a major correction, I have become more nervous. And I am taking nothing for granted for the rest of this year and 2008.
Yes, I am maintaining a cautiously bullish stance. But I believe heightened volatility is likely to be a constant companion as equity markets push higher. The basic flaws in the US economy - superficially, the housing downturn but more fundamentally, American over-consumption - remain unresolved.
Liquidity injections and rate cuts by the US Federal Reserve have stabilised financial markets, but are likely to exacerbate the global savings imbalance by propping up US over-consumption and worsening the twin deficits.
The fault lines in the fundamentals are likely to manifest themselves in coming months in, among other things, progressively higher spikes in equities volatility, periodic threats of an unruly unwinding of the yen carry trade, growing fears of a recession in the United States alternating with concerns that pump-priming measures could result in inflation down the road, and persistent jitters over the amount of leverage in financial markets. There is much for equity bulls to be nervous about.
I have identified five broad sources of tension in asset markets:
While equity valuations globally are still moderate relative to their 10-year ranges, a slowing US economy is likely to dampen earnings growth as liquidity drives stock prices higher. This will gradually push up price-to-earnings and price-to-book multiples. Similarly, while there is still a yield gap in favour of stocks over government bonds in both the US and Europe, the gap will narrow as stock prices rise.
There will be tension between the Fed's stimulatory actions and the likely worsening of the US twin deficits - already manifest in the recent downward pressures on the US dollar.
A conflict between the recovery in risk trades and growth in the global savings imbalance - both of which will be fuelled by the same rush of liquidity.
The 'magic bullet' of rate cuts that recently restored market stability will also exacerbate the leverage that was a root cause of the instability to begin with.
The contradiction between price and volatility in the equities market - as in the late 1990s, both are likely to rise in tandem. Spikes in volatility are likely to trigger the unwinding of currency carry trades and sharp declines in equity and commodity prices.
But liquidity is likely to be a deciding factor in asset prices. Cheap money - and the huge amount available - is a powerful driver of risk appetites and asset prices. Injections of temporary liquidity by central banks and rate cuts by the Fed are likely to continue driving asset markets. That's the bottom line.
However, liquidity makes for short memories - the pain of July-August now appears almost forgotten in the scramble for returns. And short memories make for bad economics and reckless investment strategies. I am taking the middle path. With rising tensions in global financial markets, unmitigated bullishness would be reckless, cavalier. But given the still-moderate valuations in equities, the oft-mentioned flood of liquidity, the low cost of funds, high returns on equity (ROE) globally and the generally still robust state of the global economy, there remains a strong argument that stock prices could push considerably higher yet.
So I continue to be bullish about equities - for now anyway. But I am by my own admission a nervous bull. I see the potential for financial blow-ups, much like that in July-August, around any of the fundamental flaws and tensions outlined above.
While I do not see much tactical advantage in US Treasuries at current yields, they are now more important than usual as diversification and negative correlation tools in the event of market turbulence or financial crisis.
It would also be sensible to seek out, for any core portfolio, strong-performing, multi-manager/multi-strategy funds of hedge funds with low correlations to equity markets.
I would reduce exposure to commodities, particularly base metals, for two reasons. One, demand-supply dynamics are likely to turn less favourable next year. Two, they have recently exhibited a correlation with equities and other risk trades. That is, there is obviously a speculative element in commodities beyond end-user demand - something that will rise and fall in tandem with risk appetites and inversely with equities volatility. Indeed, the crude oil market currently shares the same characteristic with industrial metals of being speculative demand-driven.
Buying some yen on weakness is another hedge against both the threat of an unruly unwinding of the currency carry trade but also against equities volatility. And although the price of gold could pause after a strong run-up, over the longer term it could be another useful hedge - against US dollar weakness and related currency/equity market turmoil.
Remember, when the end comes for the equities market, it is likely to be an extremely ugly affair all round - with all manner of correlated risk trades biting the dust in spectacular fashion.
That includes commodities (including crude oil), emerging market and high-yield debt, and currency carry trades.
Those already sitting on profits on risk trades should consider repositioning the gains into non-directional plays. For example, instead of betting that crude oil will head for and above US$100 - a brave call - they may consider a structure that goes long the 12-month crude oil contract and short the one-month, given the US$9 'backwardation' difference between the two. Instead of a long Asia ex-Japan position, they may consider a structure that pays on outperformance of Singapore's STI versus Japan's Nikkei. And instead of outright long positions on equities, they should consider structures that allow some upside participation while offering some downside protection.
The markets are in full rally mode - with some markets such as China in bubble territory with trailing price to earnings ratios running at 60 times. This may be the most profitable leg of the bull market. But it is also the most dangerous.
Lim Say Boon is chief investment strategist with Standard Chartered Bank, Group Wealth Management
Heightened volatility is likely to be a constant companion as basic flaws in the US economy remain unresolved
By LIM SAY BOON
FOR the past 18 months, I have maintained my bullish equities stance in the face of three major corrections - the emerging markets meltdown, the Shanghai-led correction and the recent credit market crisis.
But with each 'survival' of a major correction, I have become more nervous. And I am taking nothing for granted for the rest of this year and 2008.
Yes, I am maintaining a cautiously bullish stance. But I believe heightened volatility is likely to be a constant companion as equity markets push higher. The basic flaws in the US economy - superficially, the housing downturn but more fundamentally, American over-consumption - remain unresolved.
Liquidity injections and rate cuts by the US Federal Reserve have stabilised financial markets, but are likely to exacerbate the global savings imbalance by propping up US over-consumption and worsening the twin deficits.
The fault lines in the fundamentals are likely to manifest themselves in coming months in, among other things, progressively higher spikes in equities volatility, periodic threats of an unruly unwinding of the yen carry trade, growing fears of a recession in the United States alternating with concerns that pump-priming measures could result in inflation down the road, and persistent jitters over the amount of leverage in financial markets. There is much for equity bulls to be nervous about.
I have identified five broad sources of tension in asset markets:
While equity valuations globally are still moderate relative to their 10-year ranges, a slowing US economy is likely to dampen earnings growth as liquidity drives stock prices higher. This will gradually push up price-to-earnings and price-to-book multiples. Similarly, while there is still a yield gap in favour of stocks over government bonds in both the US and Europe, the gap will narrow as stock prices rise.
There will be tension between the Fed's stimulatory actions and the likely worsening of the US twin deficits - already manifest in the recent downward pressures on the US dollar.
A conflict between the recovery in risk trades and growth in the global savings imbalance - both of which will be fuelled by the same rush of liquidity.
The 'magic bullet' of rate cuts that recently restored market stability will also exacerbate the leverage that was a root cause of the instability to begin with.
The contradiction between price and volatility in the equities market - as in the late 1990s, both are likely to rise in tandem. Spikes in volatility are likely to trigger the unwinding of currency carry trades and sharp declines in equity and commodity prices.
But liquidity is likely to be a deciding factor in asset prices. Cheap money - and the huge amount available - is a powerful driver of risk appetites and asset prices. Injections of temporary liquidity by central banks and rate cuts by the Fed are likely to continue driving asset markets. That's the bottom line.
However, liquidity makes for short memories - the pain of July-August now appears almost forgotten in the scramble for returns. And short memories make for bad economics and reckless investment strategies. I am taking the middle path. With rising tensions in global financial markets, unmitigated bullishness would be reckless, cavalier. But given the still-moderate valuations in equities, the oft-mentioned flood of liquidity, the low cost of funds, high returns on equity (ROE) globally and the generally still robust state of the global economy, there remains a strong argument that stock prices could push considerably higher yet.
So I continue to be bullish about equities - for now anyway. But I am by my own admission a nervous bull. I see the potential for financial blow-ups, much like that in July-August, around any of the fundamental flaws and tensions outlined above.
While I do not see much tactical advantage in US Treasuries at current yields, they are now more important than usual as diversification and negative correlation tools in the event of market turbulence or financial crisis.
It would also be sensible to seek out, for any core portfolio, strong-performing, multi-manager/multi-strategy funds of hedge funds with low correlations to equity markets.
I would reduce exposure to commodities, particularly base metals, for two reasons. One, demand-supply dynamics are likely to turn less favourable next year. Two, they have recently exhibited a correlation with equities and other risk trades. That is, there is obviously a speculative element in commodities beyond end-user demand - something that will rise and fall in tandem with risk appetites and inversely with equities volatility. Indeed, the crude oil market currently shares the same characteristic with industrial metals of being speculative demand-driven.
Buying some yen on weakness is another hedge against both the threat of an unruly unwinding of the currency carry trade but also against equities volatility. And although the price of gold could pause after a strong run-up, over the longer term it could be another useful hedge - against US dollar weakness and related currency/equity market turmoil.
Remember, when the end comes for the equities market, it is likely to be an extremely ugly affair all round - with all manner of correlated risk trades biting the dust in spectacular fashion.
That includes commodities (including crude oil), emerging market and high-yield debt, and currency carry trades.
Those already sitting on profits on risk trades should consider repositioning the gains into non-directional plays. For example, instead of betting that crude oil will head for and above US$100 - a brave call - they may consider a structure that goes long the 12-month crude oil contract and short the one-month, given the US$9 'backwardation' difference between the two. Instead of a long Asia ex-Japan position, they may consider a structure that pays on outperformance of Singapore's STI versus Japan's Nikkei. And instead of outright long positions on equities, they should consider structures that allow some upside participation while offering some downside protection.
The markets are in full rally mode - with some markets such as China in bubble territory with trailing price to earnings ratios running at 60 times. This may be the most profitable leg of the bull market. But it is also the most dangerous.
Lim Say Boon is chief investment strategist with Standard Chartered Bank, Group Wealth Management
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