A myriad of factors, from plunging oil prices to confusion over China's policy intentions, have whipped equity markets worldwide into a historic risk-off frenzy at the start of the year.
No major market and asset class was spared the volatility coursing through the global financial system the past few weeks. Here in Singapore, the Straits Times Index has sunk 8.8 per cent year-to-date, for a cumulative 26 per cent since its April 2015 high. Barring a brief period during the global financial crisis, the local equity market is now trading at its lowest in 10 years on 12-month forward price-to-earnings.
RISING RATES AND FALLING CURRENCIES
Elsewhere in the region, rates and currencies have increasingly also become focal points.
As the Chinese yuan weakened, most Asian currencies, including the Singapore dollar, also slipped, losing as much as 2-3 per cent year-to-date. And as the US Federal Reserve looks set to continue raising rates following its lift-off last December, expectations over the pace of rising rates in the region have also intensified. Most notably in Hong Kong, the three-month interbank rate has spiked 30 basis points in two weeks to 0.7 per cent as the US dollar-Hong Kong dollar (USD-HKD) exchange rate climbed to a four-year high of 7.82.
Markets are speculating that a devalued yuan could prompt the Hong Kong Monetary Authority (HKMA) to loosen the reins on the 7.75-7.85 USD-HKD peg. We think this is highly unlikely - with foreign exchange reserves of some US$358.8 billion (S$513 billion) as of end-2015, the HKMA will remain both able and willing to defend the peg. This is especially so when pegging the Hong Kong dollar to the yuan is not a feasible alternative, given that the Chinese currency is not a freely tradable currency.
Still, while we expect the USD-HKD currency board to withstand potential speculation about a Hong Kong dollar devaluation as it has in recent decades, investors should brace themselves for higher interest rates - the Hong Kong three-month Hibor could reach 2.5 per cent in 12 months from 0.7 per cent today.
This comes at a time when Hong Kong's indebtedness is at a cyclical peak, Chinese tourist spending is declining, and exports are weakening with China in slowdown mode. Pressures on the Hong Kong real estate market could likely mount. As it is, home prices have already fallen some 8.5 per cent since last September's peak and could well decline a further 10 per cent this year.
As for Singapore, interest rates also look set to track US rates higher. We expect the three-month Singapore dollar Sibor to hit 2.2 per cent over 12 months and the Singapore dollar to trade at above 1.45 against the US dollar in the next six months.
THE PITFALLS...
But beyond local concerns, avoiding global pitfalls in the current economic climate will be key for portfolio performance. Of the global risks we watch, several could continue to drive the current two-way volatility in markets.
One, the widening gap between weak global manufacturing and stronger services performance is raising fears of an impending global recession. We think the risk is low as long as developed market consumers hold up, but the divergence could keep the market on edge.
Two, the surplus in oil production over demand will likely keep oil prices volatile. Markets fear the collapse in oil because energy is viewed as a gauge of global demand, even when excess supply has been the main cause of price pressures. The economic impact of lower oil prices is net positive, but the drag on market sentiment could remain for as long as oil fails to find some stability. This bears watching.
Three, China has to be better at convincing markets of its policy intentions. We do not think China will lose control of the yuan - the People's Bank of China is striving for currency stability within a trade-weighted basket, which likely means a controlled depreciation of the yuan against the US dollar. However, as China learns to adjust to varying market perceptions, heightened sensitivity to its changes in policy framework will likely persist.
Four, the Fed would have to sound more dovish to calm markets - the Federal Open Market Committee's own "dot plot" still suggests four rate hikes this year versus the futures market, which is now pricing in just one to two.
...AND THE LONGER-TERM OPPORTUNITIES
Tactically, we judge that the risk-reward trade-off on global equities is balanced over the next six months, given how sensitive global stock markets are to even small disappointments in macroeconomic news. Disciplined risk management will be critical as the sell-off has been as much about confidence as it has been about concerns over economic fundamentals.
This said, typical conditions that portend the start of sustained bear markets are absent - the global economy while sluggish is still expanding modestly, the earnings cycle is not in recession, central banks globally remain dovish, thanks to structural deflationary pressures, and equity valuations are not stretched.
Accordingly, while investors should step carefully and hedge where appropriate, the recent sell-off has created opportunities for long-term investors to put their cash to work in selected financial assets. Globally, we see value in euro-zone equities, and European high-yield credit.
In the region, we believe that China and Singapore equities are deeply oversold and present opportunities for more patient investors. Quality stocks, such as industry leaders in Asian high-growth services sectors in Internet, insurance, as well as selected large-cap banks and high-yielding stocks, also present opportunities.
In the credit space, constructive Chinese onshore liquidity and sharply lower bond issuances also favour select Chinese credits, although returns will likely be mostly limited to coupon carry.
• Tan Min Lan is Apac regional head at the chief investment office of UBS Wealth Management.
