Central Banks Are Changing Their Tune

• Growth globally is synchronised and leading indicators suggest continued expansion this year
• Major central banks are changing their tune, and monetary policy is likely to be tightened gradually
• A higher volatility regime is ahead; investors ought to lower duration risks and pay attention to valuation multiples in equity markets
• Actively-managed strategies will be vital for navigating the market environment

Growth Is Back

Since the dark days of the 2008 Global Financial Crisis (GFC), major central banks have responded by easing monetary policy in unconventional ways (such as asset purchases and even negative policy rates). These actions were done in order to stimulate overall growth by easing financial conditions and lowering the costs of borrowing for businesses and consumers.

And after all the years of stimulus, global growth has finally returned and is synchronised, as conditions improved across both the developed and emerging world. Major institutions like the International Monetary Fund (IMF) have been revising their estimates for global GDP in response.

Leading Indicators Suggest Continued Expansion

Within the US alone, corporations are increasingly confident of prospects, and this is inferred from various sentiment surveys. The CEO Index and the Philadelphia Federal Reserve's (Philly Fed) Future capital expenditures survey indicate that American businesses are planning to invest more moving forward.

Chart 1: Corporate Confidence At Cycle Highs

Leading indicators everywhere else, whether it’s the developed economies or emerging markets, point to continued expansion as well. Chart 4 below shows the readings of the Global Purchasing Manager Index (PMI) for the composite, manufacturing and non-manufacturing segments since March 2015. Readings are above the critical 50.0 level (expansionary territory), and have gradually been on an uptrend since 2016.

Chart 2: Global Purchasing Manager Indexes (PMI) Since 2015

These leading indicators together suggest that inflationary pressures are building, particularly when the pick-up in growth momentum is synchronised at this juncture.

Change In Tone – Monetary Policy Normalisation Will Continue

We expect policy-makers to continue normalising monetary policy as growth and inflation picks up.

The chart below shows the number of times that various members of the Federal Open Market Committee (FOMC) have mentioned ‘strong labour market’ and ‘removal of accommodation’ in official speeches and conferences. The frequencies have steadily risen since 2014.

Chart 3: Frequency Of References By FOMC Members Since 2010

Over in Europe, the appearance of the words ‘inflation’ and ‘recovery’ have crept up since 2015. This is a healthy sign of growth being increasingly entrenched in the Euro-region, as the bogeyman of Deflation has haunted the minds of policy-makers since the Sovereign Debt Crisis.

Chart 4: Frequency Of References By ECB Members Since 2010

Clearly, central bankers are acknowledging improving growth dynamics, and have communicated publicly their intentions to gradually normalise their respective monetary policies, via balance sheet reduction and higher policy rates.

Implications For Investors

A Higher Volatility Regime Is Ahead

As the major central banks slowly unwind their stimulus programmes, the perpetual bid pressure on assets that they have been purchasing will gradually decrease, and this will lead to a higher volatility regime as compared to what we have seen over the past seven years (persistently low volatility).

More volatility could be expected not just in equity markets, but also in fixed income and currency markets, particularly if the pace of normalisation by various major central banks are not simultaneous and differ in duration and pace.

Chart 5: Implied Volatility Across Bonds, Equities & FX Since 2000

This implies that SGD hedges are still relevant for investors, particularly for your fixed income portion of your portfolio. The hedge will help to mitigate adverse effects from currency fluctuations vis-à-vis the SGD when volatility picks up there.

Lower Your Duration Risk, Minimise Exposure To "Bond Proxies"

Apart from central banks slowly stepping away from purchasing assets, policy rates are expected to be gradually hiked. The Fed has led the way in this, but other central banks like the European Central Bank (ECB) is expected to eventually normalise interest rates going forward.

In bond markets, you need to lower duration exposure, as the higher an asset’s duration, the more sensitive it is to changes in interest rates. That is why we have been advocating short duration fixed income. We believe the short duration space is the best bet for capital preservation until valuations are more attractive across bond markets.

Secondly, you would also want to lower your exposure to the riskier segments of bond markets (valuations are pricey), as market participants realise that the opportunity costs of not owning them will decrease as risk-free rates go up. These are spread segments such as the high yield markets.

Additionally, you also need to lower exposure to ‘bond proxies’. Utilities are an example of bond proxies, due to their defensive characteristics and how they are perceived by income-seeking investors to be yield instruments. Naturally, a further rise in risk-free rates will affect their valuations since they are akin to fixed income instruments.

If you are actively stock-picking, you will want to go for companies that have business models that are structured to protect their earnings or even benefit from a rising interest rate environment.

Normalisation In Equity Valuation Multiples

Higher risk-free rates will change valuations of assets, as the present value of future cash flows are discounted at higher interest rates. This implies a normalisation in valuation multiples of equity markets.

Thus, operating within a margin of safety becomes vital. Finding equities that trade below their fair valuations will give you a larger buffer as risk-free rates rise. For the markets under our coverage, the western developed markets have valuations that are more than normalised at the moment, hence, our preference for emerging markets over their developed counterparts (check out our Star Ratings to see which markets we like).

Active Management Is Vital

With a higher volatility regime and normalisation of valuation multiples, passive investing strategies may not be optimal. As we pointed out here, institutional investors have been preparing themselves and are majority of them believe that the current environment favours active management.

Actively-managed strategies can use flexible positioning to eke out returns in bond markets as risk-free rates rise or to preserve capital when the time calls for it. In equity markets, richly-valued sectors can be avoided or underweighted, and neglected assets that are cheap relative to their upside potential could be scooped up. These sort of actions will greatly add value to your portfolio when multiples rerate in the future.

Additionally, active managers can defensively position their exposure, which helps in managing drawdowns and risks in volatile market environments. This is a clear advantage that passive indexing cannot provide.

To Sum Up…

Cycles are an inevitable feature of the universe, and as Ecclesiastes proclaimed, “there is a season and a time for everything under the heaven”. Financial markets also ebb and flow, and as investors, we have to be aware to the changing dynamics and adjust accordingly.

As growth and inflation pick up, central banks are no longer at the backs of investors as they gradually normalise their respective monetary policies. Ensure that your portfolio is appropriately positioned for this market environment!

The Research Team is part of iFAST Financial Pte Ltd.