BT: Stick with equities, diversify your portfolio (27 Jun 2007)

Stick with equities, diversify your portfolio

Though equities friendly, the current correction is likely to be drawn out & desynchronised

By LIM SAY BOON

THE ongoing correction in the global equities market at the end of the second quarter has been almost orchestrated. And the corollary to this is that the markets have so widely anticipated this correction that it is likely to turn out shallow.

And instead of a short, sharp correction, this is more likely to be a drawn-out, desynchronised affair, with bounces in between. And so far, the correction has been playing out pretty much to expectations. But beyond this, the global economic environment remains equities-friendly and I expect higher prices yet by the end of the year, despite rising risks.

The US economy, instead of sliding into recession as some had feared, has had a very well-cushioned landing; the growing problems with sub-prime mortgages have yet to make an impression on US consumers, and the global economy continues to run hot. Indeed, perhaps a little too hot for comfort.

Concerns have now turned to the threat of inflation in 2008 derailing the equities bull market. And while there are some grounds for fearing consumer price inflation down the line, the threat is at most only tentative at this stage. A bigger concern now among investors is missing out on the asset inflation that is clearly evident all around the world. Almost everywhere in the world - and Singaporeans too have been seeing this up close over the past year - the phenomenon is manifest in both the equities and property markets. More on this later - but first let's get back to the equities correction.

It started, once again, in China. But unlike the case at the end of February, China's correction this time was widely expected. The market had been abuzz for weeks prior to the start of the correction with talk of government moves to cool the overheated Shanghai market. The correction in the major developed markets were almost clockwork in their timing with the 'sell in May' dictum.

Indeed, even the reasons for the correction were telegraphed way in advance. In my weekly 'Market View' report for Standard Chartered Bank clients, I started warning by mid-May that 'a likely source of disappointment for the equities market was rate cut expectations'. That is, the market was going to have to moderate if not abandon its expectations of US interest rate cuts. And again, early June, I cautioned that the S&P500 index was showing signs of strain under the weight of rising US Treasury yields. And then there were those tell-tale technical 'divergences' that had been spotted by more than a few chartists - ah, the summer holidays are approaching.

But beyond this seasonal weakness, the global environment remains pretty bullish. Indeed, a quick scan of the economic news flow of recent weeks suggests the global economy may have fairly quickly got over that soft patch everybody was talking about earlier in the year.

In the US, consumer confidence and consumption spending have held up despite the downturn in housing prices. Jobs and wages are critical in this regard. And the US unemployment rate has been declining over the past four years and average hourly earnings have been rising over that same period. On top of that, household balance sheets are in good order. Businesses have also been doing well, with corporate profit growth still running close to historic peaks. Indeed, the recent surge in US Treasury yields reflects this resilience in the US economy.

The eurozone is now running at above trend growth, supported by strong broad money supply growth. This strength is highlighted by its robust domestic demand, with consumer confidence surging as unemployment dives. Notably, unemployment has now hit the European Central Bank's (ECB) estimated 'Nairu' (non-accelerating inflation rate of unemployment) limits. This suggests that if the economy runs any hotter, the ECB is going to be more nervous on inflation - which is why the market is now looking at the possibility of two more rate hikes.

Indeed, a quick survey of the global economy suggests that on the Goldilocks 'too hot, too cold' scale, we are on the warm side of 'just right'.

In the UK, property prices are still running hot; the financial sector is booming; and inflation is running significantly above the Bank of England's 2-per-cent target. Significantly, Governor Mervyn King joined a group of dissenters (four out of a group of nine) who voted unsuccessfully for a rate rise last week, leaving the market suspecting another two more rate increases before the year is done.

And the commodity economies of Canada and Australia are also looking at capacity utilisation, domestic demand and inflation rates around the limits of their respective central banks' tolerance. And in both economies (but more so in Canada than in Australia) further rate rises are likely before their cycles are over.

Inflation

India has been running way too hot for its central bank's comfort and rates have been aggressively ratcheted up. Indeed, there seem few economies running on the 'cold/cool' side of the scale.

Even in China, a key exporter of deflation over recent years, dthe headline inflation figure has ticked up. And while it is still too early to make any calls on consumer inflation, the Chinese government will still have to deal with asset inflation in equities and high-end properties. And this means further rate increases.

Indeed, what will spoil the equities party is if significantly higher inflation and interest rates take hold globally. Apart from raising business costs, the higher discount rate for equity valuation will then lower fair valuation estimates. But currently, rates are still at historically low levels; price-to-earnings valuations are still at the lower side of most markets' recent 10-year ranges; and the amount of excess liquidity running through most of the global economy is likely to continue driving asset prices higher.

Singaporeans are now seeing for themselves, first-hand, the pain (and cost) of missing out as prices for assets - including homes - are rapidly pushed higher. Certainly, holding fixed deposits at 2 per cent or less only intensifies the urge to splurge on assets. This is a global phenomenon.

Given current low interest rates, it is likely to take more than another 25 or 50 basis points in rates to curb the appetite for risk - especially against the backdrop of a still robust global economy, with companies turning in high earnings growth and returns on equity. To be sure, risks are rising as the markets - for both financial and real assets - surge even higher. And the speed of recent gains has pushed selected markets into what is likely to be the late stages of their bull cycles. And, as in the late 1990s, there could be shocks involving hedge funds or specific risk assets - such as collateralised debt obligations which recently hit the headlines as a result of the problems at Bear Sterns.

And indeed, analysts already fear that China is already a bubble. Comparisons have been made with the Nasdaq bubble in the late 1990s (see accompanying chart).

Three things can be said about this:

One, if the China stock market bubble bursts, the fall-out is likely to be limited for the Chinese economy and global markets in general, given the apparently relatively few linkages between the Chinese stock market and its real economy.

Two, the majority of global markets are nowhere near the bubble-like conditions of the Chinese economy. And finally, manias - even when they become manifest - can go on longer than logic might suggest. Indeed, if history is any guide, the later stages of the bull market can also be the most explosive.

I would stay invested in equities. But I would also be looking for returns from structured equities products with downside protection; I would be looking to buy inflation hedge through 'TIPs' (Treasury inflation protected securities); I would buy products that pay off in the event of surges in volatility. And I would be diversifying my portfolio both by geography and by asset class.

And I would watch bond yields like a hawk.

The writer is chief investment strategist for Standard Chartered Bank, Group Wealth Management

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