Financial markets are entering a more dangerous phase. The lower risk-to-reward money has been made in stocks, bonds and the US dollar. At these levels, further gains will be driven more by idiosyncratic factors - that is, circumstances specific to each market - than broad asset class themes.
Stock prices have surged from 2009. But economies have struggled. This is the "Great Disconnect" between economies and markets over the past six years. The US economy had averaged around 2 per cent real GDP growth per year since the global financial crisis. But the S&P500 had moved up 220 per cent from its 2009 lows.
The link is the growth in the Federal Reserve's balance sheet, which is up 140 per cent. And it's much the same story in the euro area and Japan, where both economies have been struggling in and out of recession but stock prices have soared. Thanks again to central bank asset purchases.
And it's also about the cost of money. The lower the interest rate, the more investors are prepared to pay for assets. It's the inverse relationship between the net present value - the discounted cash flow - of any asset and interest rates.
So, valuations in developed market equities are either at or approaching cyclical peaks. Meanwhile, low interest rates also mean higher leverage. Margin debt on the New York Stock Exchange, as a percentage of GDP, has busted previous cyclical peaks (see Chart 1).
But none of this necessarily spells the imminent end of the equities bull market. Indeed, stock prices could push yet higher on the lack of attractive alternatives. Even with interest rate hikes likely in the US later in the year, cash rates will remain low by historical standards. And if equities are expensive, bonds are even more expensive, valued against long-term averages.
So we remain invested. But we are taking a more selective approach, taking weight off some markets. We are downgrading US equities to neutral. The US Treasury yield curve - the spread for the 10-year yield over the 2-year yield - does not speak of either recession or bear market over the coming months.
The flattening and inversion of this spread has been a powerful predictor of US recessions and bear markets going back to the 1990s. Today, it is still some way from inversion. But the lower risk-to-reward money has been made. And US corporate earnings growth is stalling at a time when valuations are high and interest rates are set to rise.
We remain overweight in Europe and Japan, which are at earlier stages of the monetary policy cycle.
While Chinese equities should push higher on further policy stimulus, they too are entering a more dangerous phase. The Shanghai Composite, which had gone up more than 150 per cent from the middle of last year to the recent peak, has been correcting. It is arguably in the interests of Chinese policy makers to maintain a supportive environment for domestic equities for a while yet.
Strong stock prices encourage consumer spending via the wealth effect, potentially offsetting some of the slowing of economic growth. Also, high stock prices can be useful in raising funds for resolving troubled assets elsewhere in the economy. We are keeping a watchful eye on funds raised on the Shanghai Stock Exchange, which have already risen to cyclical highs (see Chart 2).
Meanwhile, valuation in A-shares has moved up to the higher end of the cyclical range. We are downgrading A-shares from overweight to neutral. H-share valuations are more moderate. We stay overweight H-shares.
Emerging Markets ex-Asia equities remain unattractive. Historically, they underperform in strong dollar and weak commodity environments.
But even in the currency markets, the risk-to-reward proposition for bullish dollar positions has become less attractive, as a result of the 38 per cent rise in the US dollar index (DXY) from its 2011 low to its recent high.
Bond yield differentials should move in favour of the dollar as the Fed's policy rate moves higher. But the mid-cycle correction in the DXY could go deeper and last longer before the dollar eventually moves higher. And again, there may no longer be a single, overarching dollar theme. Instead, there may be divergences in the performances of different currencies against the greenback on idiosyncratic factors.
Since 2009, there have been rotating monetary expansions between major economies to support growth via competitive devaluations. This is a zero-sum game, a beggar-thy-neighbour policy tool. And there are limits to the size and speed of currency appreciation the US can absorb against any number of other currencies. There will be greater sensitivity in the market towards marginal changes in economic relativities between the US and other economies, and hence greater volatility.
The downside risk for commodities as a broad asset class has diminished dramatically, given the 44 per cent decline in the broad commodities index from its 2009 peak. But oversupply remains a problem in a range of commodities. Selectivity will be critical.
The price of crude oil remains vulnerable. Just as shale oil activity eased rapidly in response to the decline in the price of crude, it is likely to respond similarly but in reverse to any sustained price rise, thus turning the US into a new "swing gate producer". Crude is likely to continue trading in a range capped at around US$60 a barrel.
Over the next 12 months, improved demand-supply fundamentals could see stronger prices for lead, zinc, nickel and tin. Meanwhile, iron ore prices could fall yet lower on the price war under way between giants Rio Tinto, BHP and Vale versus smaller miners.
Lim Say Boon is Chief Investment Officer, Consumer Banking & Wealth Management, at DBS Bank.