Despite the unwelcome return of Covid-19 to Singapore’s shores, things are looking up for the global economy as a whole. This recovery has naturally seen fears of inflation perking up, with US 10-Year Treasury yields sharply rising from near-zero levels last year to around 1.63% as of May 17. US markets are thus increasingly shifting into value plays to hedge against this reflation as talk of a “taper tantrum” is fearfully whispered among investors fearing an interest rate hike.
For ESSEC Business School’s associate professor of economics Jamus Lim, however, such fears are largely unfounded. He notes that while inflationary pressures are indeed rising with economic recovery, they remain relatively quiescent for now and close to the targets set by central banks. Wage inflation has been relatively limited thus far, while money supply growth — the main inflation risk this round — has already begun to taper.
Currently, inflation expectations in global markets with exception of the US are just returning to pre-pandemic levels. US markets, however, are pricing in inflation that exceeds Federal Reserve (Fed) targets.
Lim says this is not unexpected as the Fed has already telegraphed a willingness to tolerate some inflation beyond its target. It is only likely to raise rates if expectations are persistently and significantly higher than targets.
Lim was speaking at The Edge Singapore’s mid-year investment forum entitled New Era, New Landscape, New Trends. Held online on May 15, he was joined on a panel of three speakers by TD Ameritrade Singapore CEO Christopher Brankin and Heritage Global Capital Fund portfolio manager Goh Tee Leng.
Another driver of inflation has been in the area of commodities, with agricultural commodities in particular seeing strong price increases. While industrial metals have also seen increases, more indicative metals such as copper have been reasonably quiescent. The contribution from energy inflation is also significantly lower compared to even five years ago.
While price movements may hint at the potential onset of a commodity supercycle, Lim is sceptical about such an outcome. “For me, the macro fundamentals don’t quite point to the emergence of a supercycle quite yet,” he says, noting that the previous supercycle was largely driven by the entry of China into global value chains. No economy or group of economies has yet emerged to provide sustained demand support for commodities at a similar scale, he adds.
Still, Brankin says that with demand for commodities outstripping supply worldwide in the short-term, it is worth taking note of this spike in commodity prices when making investment decisions. More broadly, he also sees the likely short-term nature of inflation potentially creating an opportunity for buying tech stocks on the cheap. Investors concerned about inflation, meanwhile, should make a switch into value plays.
“From 1926 to 2020, inflation averages 2.9% and equities have significantly outperformed inflation,” Brankin argues. With stocks averaging 10.3% during this period, having some stock market exposure has been more profitable for investors than keeping up with inflation with fixed income or bonds.
The moral of the story, it seems, is to stay invested in the equity markets.
Value versus growth
Despite the recent rotation away from growth into value, the pandemic has perhaps called into question value investing as an investment strategy. With the pandemic having exponentially increased the pace of digitalisation, there are fears that focusing too much on stock valuations would see investors miss out on the seemingly unstoppable rise of tech stocks. Brankin notes that while markets are a little stretched, current valuations are not out of line with expectations.
Yet, it is not necessarily the case that there is a strict dichotomy between growth and value. What counts as growth and value, says Goh, depends on how one defines value.
“Value should shift with the times. What my grandfather would see as value may not be what I see as value in today’s times,” he explains. The high valuations of tech stocks nowadays could well be the new normal as demand for digital transformation grows.
For instance, Australian fintech firm Afterpay has seen valuations rise exponentially over the previous year, with the stock’s price rising 15 times from March last year to Feb 25. But rather than purely due to investor speculation, Goh (who owns shares in this stock) attributes this rise to Afterpay’s entrance into the US e-commerce market — which is 10 times larger than the Australian market — meaning that the stock’s higher valuation can therefore be justified.
This calls to mind comments by OCBC economist Howie Lee, a panellist at last year’s Year End investment forum. With tech companies often operating based on intangible rather than tangible assets, investments put into tech firms are often not capitalised, and are thus instead reflected as expenses in the profit and loss statement. This leads to negative operating cash flows and somewhat depressed profit margins that scare away would-be value investors.
“Tech stocks are in a world of their own and we cannot apply traditional metrics,” OCBC’s Lee said last year. For Goh, he uses the enterprise valueto-sales (EV/S) ratio as a rough guide to value tech stocks, asking himself if valuation multiples get compressed over the next five years to a more sane figure of about eight to 12 times, from the 50 to 100 times they are currently trading at. He also considers if a company’s revenues can continue growing at a healthy rate as well as its ultimate compound annual growth rate (CAGR).
Lim also suggests that investors could use valuation factors to value such stocks. This allows investors to observe if a given stock has a stronger or weaker correlation than average with a given factor, revealing certain stocks that may not be traditionally considered overvalued or undervalued. Investors can thus seek out new factors tailored to the particular characteristics of tech companies, allowing for more accurate valuation than existing metrics.
The fact that stock prices seem completely untethered from fundamentals should not be taken as an excuse to dismiss value investing altogether. “At the end of the day to me as an investor, companies that I am investing in should be of good quality and growing. The stock price is more of a bonus. Eventually, I find that the stock price will catch up with the fundamentals in the long-term,” says Goh.
People, he adds, often have unrealistic expectations of how well their investments can perform, penalising consistent performers for temporary underperformance and rewarding poor performers for temporary good performance.
The big picture
However, valuations cannot be made in isolation from the wider macro environment. Goh warns that while Chinese tech stocks will benefit from China’s rise to become the next global superpower, they are typically subject to unique political and regulatory risks. Moves by Beijing to penalise Alibaba and investigate Meituan, he says, highlights how investors need both caution and a better grasp of China’s political and regulatory environment to invest in such stocks.
In the US, investors are also concerned that Chinese American depositary receipts (ADRs) could be delisted in US markets amid the US-China geopolitical conflict. Markets, Brankin says, like clarity. He also observes that TD Ameritrade clients are moving to reduce their exposure to these assets. He says that investors can access similar growth prospects via US tech stocks, since these are typically exposed to less regulatory and political risks.
The strong fiscal stimulus in the US at the moment has also had a positive impact on growth. Projections for US gross domestic product (GDP) growth are a solid 7% to 8% for 2Q2021 on average, which could see growth spill over into other economies.
While China’s rebound has been the most impressive among economies, Lim says that Beijing’s shift towards more inward-looking and service-oriented growth will see less of its growth spilling over than during the Global Financial Crisis in 2008.
Based on 95% of S&P 500 companies reporting their 1Q2021 results, 76% have seen a positive revenue surprise. Meanwhile, 86% of S&P 500 firms have reported a positive EPS surprise across all 11 sectors, potentially tying for the highest percentage of S&P 500 firms reporting a positive earnings per share (EPS) growth in more than a decade. The blended earnings growth rate for the S&P 500 was 55.4% in 1Q2021, heralding the highest y-o-y earnings growth rate reported by the index since 1Q2010.
“Our customers have remained ‘risk on’. They have been adding additional market exposure, and they have been doing that every month for the last 12 months. And they have been rewarded for it,” says Brankin.
This rally has also increasingly broadened over time, with investors moving out of just the tech sectors and putting their money across the board. Taiwan Semiconductor Manufacturing Co has been the biggest net buy stock over the last six months in Asia while Facebook, Amazon and Adobe have seen the highest net sales in the region.
Diversify
Despite this bullishness, Lim urges investors to pursue portfolio diversification. Investors should rotate away from US stocks and selectively into EM Asia stocks and possibly European stocks too — especially in financials.
Investors are also rotating from large cap to small and medium cap stocks, from growth plays to value plays and from defensive sectors (like healthcare and utilities) into early cyclical (financials, energy and possibly even tourism).
In the fixed income space, Lim sees yield curve steepening this year due to increases in term premiums and expected inflation. But with real interest rates moving in the opposite direction, this will exercise a limitation on the extent to which the yield curve can steepen further. He argues that there is unlikely to be a reversal of the long-term bond bull over the past three decades into a bond bear.
Still, what the pandemic has taught us is that it is impossible to predict the future. “Black swan” events — such as a cyberattack or another pandemic — will always catch investors off guard, so prudence is a virtue in times of uncertainty.
The best advice, agree all three speakers, is to stay diversified and understand what one is investing in. “If you don’t understand what you are investing in, ask your broker,” adds Brankin.
