Principal Monthly Viewpoints (March 2021)
Q: Principal Asset Management (Asia) Investment Management Team
A: Crystal Chan, Principal Asset Management (Asia) Senior Investment Specialist
Q:Do Asian stock markets look more favourable than the others?
A: Asian countries have been relatively less impacted by the COVID-19 pandemic, and the pace of their economic recovery is further advanced compared to markets in Europe and the United States. China, for example, was one of the countries to resume work and production early under the impact of the pandemic and its economic recovery was better than expected. China's GDP grew by 2.3% last year, making it one of the only major economies in the world to record positive economic growth. Even though China is expected to focus more on risk management while supporting its economic recovery this year, it is still possible for the country’s overall economic growth rate to accelerate to more than 8%. According to the World Economic Outlook report released by the International Monetary Fund (IMF) in January, this round of the economic recovery is expected to be driven by emerging Asian markets. The region’s overall economic growth rate in 2021 may be as high as 8.3%, better than the 4.3% for developed economies and the 5.5% for the global economy.
As for valuations, the forward P/E ratio of the MSCI Asia Pacific (ex Japan) Index fell to below 17x at the end of February after recent market adjustments, marking a three-month low. In addition to falling share prices, analysts have also raised earnings forecasts for Asia-Pacific companies, making the current valuation of the markets more attractive than at the beginning of the year. On a relative basis, its investment value remains higher than that of Europe and the United States.
In the near future, the rapid rise in US interest rates will be a major risk factor for Asian stock markets. The depreciation of the US dollar has been one of the driving forces behind the upward trend of Asian stock markets for a while. There were large capital flows into the emerging markets to seek opportunities. We believe that the overall weakness of the US dollar remains intact. As we can see from the correlation between the US dollar index and the 10-year US Treasury bond in the past ten years, there is no absolute relationship between them. Since the beginning of this year, the two parameters have been negatively correlated. Since the monetary and fiscal policies are still highly accommodative, we believe that the US dollar will not rebound sharply for the time being, especially as the fiscal deficit has significantly expanded. Capital is more likely to continue to flow to high growth markets.
From a regional perspective, Taiwan, Hong Kong and Vietnam were the three best performing markets in the first two months of this year. We are still bullish about the Taiwanese and South Korean stock markets in the near-term, especially the technology sectors. A global chip supply shortage, amid stronger demand for smartphones, computers and consumer electronics products, as well as the accelerated development of electric vehicles and infrastructure will provide momentum for a continuous increase in demand for chips. The market share of leading companies is expected to expand further. These factors are beneficial to the earnings outlook of the technology sectors in Taiwan and South Korea.
Besides the fact that the technology sector makes up more than half of the index's weight, the average dividend of Taiwanese stocks is relatively higher than its regional counterparts. Even if bond yields increase, the market still enjoys a certain degree of competitiveness from the perspective of dividends, which can attract foreign investment. In addition to the technology sector, green energy, healthcare innovation and new consumption are other interesting investment ideas. The valuation of the South Korean stock market is more attractive than other regional markets. Driven by the recovery of external demand in the semiconductor and automotive sectors, the two major industries of South Korea, the country’s exports gradually made up lost ground in the second half of last year. The situation is expected to further improve this year. As for industries other than technology, with the potential increase in electric vehicle sales, the automotive sector is expected to still perform strongly this year.
In addition, the Indian stock market also looks attractive. Fundamentally, we believe that the worst period of the pandemic is already behind us. With the implementation of large-scale vaccination programmes and the support of accommodative fiscal and monetary policies, the Indian economy will recover gradually and may record double-digit economic growth this year. Corporate earnings are expected to further improve. Among various industries, the outlook for the financial sector is particularly positive. Local banks enjoy a relatively high return on equity (ROE), which may continue to benefit from better economic growth expectations and strong investment demand. The improved liquidity environment will also reduce credit risks.
Q: What are the impacts of higher US Treasury bond yields on investment markets?
A: The yields of US Treasury bonds have risen sharply as the market looks forward to an economic rebound. The 10-year Treasury yield once climbed to over 1.6%, the highest level in the past year. The sudden rise in government bond yields has caused the market to worry that the Fed will speed up the tightening process and affect market liquidity. Technology stocks were under heavy selling pressure, with the Nasdaq Composite Index once falling more than 8%. While rising interest rates may push up the financing costs of governments globally, companies and the public, high risk assets will look less attractive when US bond yields surpass the average dividend of the S&P 500. Selling pressure and market volatility are likely to accelerate further.
Traditionally, the market may experience a short-term adjustment when bond yields and inflation expectations increase. However, the stock market can maintain an upward trend as long as economic expectations remain unchanged. According to our calculation, in the ten time periods in the past 30 years that the 10-year US Treasury yield rose sharply, the S&P 500 Index recorded negative returns in four of them and positive returns in the other six, with performance ranging from -2% to +14%. This shows that a rising bond yield is not necessarily directly correlated with the development of the stock market.
The bond market, however, and particularly the investment-grade market, is quite different. In the seven periods that bond yields rose rapidly from 2000 to present, investment-grade bonds have recorded negative returns with bond prices falling by an average of about 4%. Due to the relative spread advantage offered by high-yield bonds, their returns are generally higher than those of investment-grade bonds. During the 2008-2009 period when sovereign yields surged, high-yield bonds recorded a return of more than 30% and the average returns for those seven periods were nearly 4%.
Indeed, as reflected from the 10-year bond yields, inflation expectations have bounced back to above the 10-year average. However, the rise in inflation expectations does not mean that monetary policy will shift immediately. With reference to the third quarter of 2008, as the economy recovered from the financial crisis, inflation expectations also quickly rose to above the 10-year average while the US federal funds rate remained at a record low until the end of 2015. We believe that the central banks of developed economies will not fulfill the exit requirements during this year. For example, the United States may not achieve its so-called maximum employment target and average inflation target of 2% until 2023. The debt purchasing plan is likely to stand still until the latter part of 2022 and interest rate hikes will not happen before then. Interest rates are expected to remain unchanged for at least the next two to three years. We think the chances of Fed action at the long end are rising through an increase in the weighted average maturity of their purchases, particularly if real yields continue to rise.
Q: International gold prices hit a nine-month low and oil prices are at a one-year high. What is the outlook for commodities?
A: In addition to rising inflation expectations, the rise in real interest rates in a short while also pushed up the Treasury yields. Changes in real interest rates can be observed through the yield of Treasury Inflation Protected Securities (TIPS). Taking the 10-year TIPS as an example, the bond yield (the 10-year US Treasury bond yield minus the 10-year inflation expectation) has been trending downward since mid-March last year and bounced back rapidly since mid-February this year.
Since the real interest rate and the price of gold exhibit a highly negative correlation, the rise in real interest rates can weigh on the gold price. Moreover, with the broad application of COVID-19 vaccines fueling expectations of an economic recovery, investors exited safe-havens such as gold markets. With continued weakness which began in the fourth quarter of last year, the price of gold has fallen by more than 10% this year, hitting a nine-month low.
Although the factors that triggered the decline in the gold price remains intact, the retreat may moderate in the future. The current economic recovery is still in the early stages, especially as the job market has not returned to levels from before the pandemic, the upward pace of real interest rates is likely to slow down. Meanwhile, some high valuation stocks are going through an adjustment, triggering the needs for risk aversion. Gold prices may find support at a lower level and the market will be watching if international gold prices can stay firmly at the US$1,700 level.
On the other hand, oil prices are still strengthening and rose more than 25% this year. New York oil futures broke the US$60/barrel level for the first time in more than a year, reflecting the recovery in demand and the severe cold weather in some regions. We believe that the current optimistic expectations for increased demand have been basically reflected in prices. The future price trend of the crude oil market still depends on the balance of supply and demand, especially the degree of increase in production by the Organisation of Petroleum Exporting Countries and its allies (collectively referred to as OPEC+), as well as the sustainability of the economic recovery. Oil price may fluctuate in between US$55 and US$66/barrel in the short term. If supply recovers slowly, oil prices may further accelerate.
(Written on 5th Mar 2021)
Senior Investment Specialist
Principal Asset Management (Asia)