03 August 2017
Bull or Bear Market from here? Regardless of which camp you reside, cognitive biases tend to subject us humans to seek out information that best fit our prior beliefs. For the Bears, there are plenty of negative news to nit-pick from, and the frequency of bearish newspaper articles have increased over the last few weeks. For the Bulls, the market has not yet given any sign of reversing this very long positive cycle. Here comes the boring truth: the global economy is still fine albeit trapped in a modest pace with benign inflation.
Our perspective is that it is time to respect valuations. We acknowledge that market pricing for growth-oriented assets are higher than fair and we may witness some moderate retracements in the second half of 2017. To better prepare our clients, StashAway’s investment framework adopts a systematic, strategic and forward looking approach to re-optimizing portfolios. Our framework is known as ERAA® (Economic Regime-based Asset Allocation) and it monitors relative valuations across asset classes, among other things. When valuation for an asset class deviates significantly from fair, ERAA® would adjust expected returns and risk estimates accordingly, therefore underweighting or overweighting the specific asset class in the portfolios.
As the global economy continues to reside in a “dis-inflationary growth” regime, StashAway views any short-term retracements in markets as opportunities for investors who have the discipline to commit to their long-term allocations. Investors who save and make recurring contributions to their investment plans would be able to lower their average price of entering the market. Ultimately, this improves the reward to risk ratio of one’s portfolio in the long-term.
Of late, the bears have gathered more support after members of the FOMC (rate-setting committee at the US Federal Reserve) expressed support for continued tightening of monetary policy. In particular, market participants are increasingly focused on how and when the Fed would start the process of shrinking its balance sheet. We also have to confront plenty of risk from geo-political developments in the middle-east and there are upcoming elections in Europe.
Elsewhere, as demonstrated by South Korea and Brazil in recent years, presidential impeachments are no longer far-fetched and there have been speculations of a risk of an impeachment in the US. As elaborated by “Do Presidential Impeachments Actually Affect Global Markets?”, data-driven analyses of past events reveal that presidential impeachments rarely alter the course of markets unless the economy is already in a weakened state. We continue to adopt the same principle here and recommend investors to stay focused on making medium to long-term asset allocation.
Here comes the boring truth: the global economy is still fine. Although there are no fireworks or inspiring things to say about modest growth, the improvement in economic activity has been steady since September 2015.
The US is widely viewed as the leader of the global recovery and the latest economic figures continues to show positive year-on-year growth of +2.21% (industrial production) and a controlled inflation of +1.9%; According to StashAway’s ERAA® framework , these data points place the US comfortably in the “dis-inflationary growth” regime. In other word, the economic regimes for US, China, Eurozone, Japan, Australia and Singapore remain supportive of growth oriented assets.
United Kingdom and India are the two exceptions. In the UK, aside from lacklustre growth, the weaker pound post “Brexit” has created some challenges to manage “imported inflation”. The situation in India is worrisome too – growth is tepid and rapid decline in inflation could be symptomatic of a deterioration in incomes and purchasing power.
In summary, the global economy is growing at moderate pace with low inflation, therefore creating a benign environment for growth assets. Readers interested in our economic scorecard across countries can refer to the appendix.
Let’s now look at valuations, to draw conclusions on the tactical aspects of our strategic asset allocation framework.
We acknowledge that current market valuations for growth oriented assets are higher than the fair values implied by economic factors. We present two likely scenarios for the second half of 2017 below:
Economic conditions continue to improve but at a modest pace. As valuations of growth-oriented assets have been aggressive, the market needs to see new sources of growth emerge before rallying further. Consequently, the market stays in a tight range, moving from point A to C (left chart of Figure 1).
Due to high valuations, risky assets may undergo a mild retracement in the second half of 2017. This is depicted as a move from point A to B in the right chart of Figure 1. As economic fundamentals remain resilient, strategic and long-term investors emerge to buy on the dip and asset prices recover by moving from point B to C eventually.
StashAway’s investment framework adopts a systematic, strategic and forward looking approach to re-optimizing portfolios. Our framework, ERAA®, continuously monitors relative valuations across asset classes. When valuation for an asset class deviates significantly from fair, ERAA® would adjust expected returns and risk estimates accordingly, therefore underweighting or overweighting a certain asset class in recommended portfolios.
As an example, ERAA® has been reducing expected returns for the S&P 500 by 4.5% at the end of April. In July, it further lowered expectations by another 1.2% (i.e. its adjustment to expected returns has widened from -4.5% in April to -5.7% vs the S&P 500 historical average). In practice, this means that today, StashAway’s clients have a lower percentage of S&P 500 in their portfolios than they would have had if we did not believe the S&P 500 was currently overvalued. This is true for all portfolios.
Respecting valuations ensures that portfolios reduce the inherent risk of an overvalued asset class, and benefits from the potential higher upside of an undervalued asset class.
“Someone’s sitting in the shade today because someone planted a tree a long time ago”
The global economy is steady and growing at moderate pace. Although valuations for growth-oriented assets are higher than fair and should be taken into account when building portfolios, we see any near-term retracements as opportunities for investors who commit to investing toward their long-term goals.
An investor who saves and makes recurring contributions to his or her investment plans would be able to lower the average price of entering the market. Similarly, people holding large amounts of cash should enter the markets with a staged approach. We recommend a constant monthly contributions over the course of 6, 12, 24 or 36 months, depending on the significance of the investment amounts to one’s total net-worth. Ultimately, monthly constant investing improves the reward to risk ratio of one’s portfolios in the long-term. In addition, StashAway recommends minimising (or avoiding) the use of leverage, and to strictly adhere to pre-specified risk limits.
At StashAway, we believe asset allocation should be driven by solid economic principles as economic factors are dominant drivers of asset returns over the medium and long term. Our platform builds customised portfolios that take into consideration the appropriate risk level that each unique customer should take, and the automatic rebalancing feature ensures that each customer’s portfolio does not deviate from the determined strategy. To learn more about StashAway’s investment framework, visit here.
Before we explore global economic trends, it is apt to first describe the methodology behind making an “apple-to-apple” comparison. With the exception of China  and Australia , we proxy growth with the respective year-on-year changes in industrial production, as shown in Figure 2. As the volatility of economic data differs by country, we measure growth in terms of its “number of standard deviation from long-term mean”. This is estimated for the period between January 1982 and May 2017.
The US has led global recovery and the positive spill-over to other parts of the world is apparent and significant. Notably, the improvements in growth scores for China, Singapore and Japan are even larger than the US. In September 2015, the growth score for China was -1.9 which can be interpreted as Chinese growth being 1.9 standard deviation below its long-term historical average. As the latest figure is +0.04, China’s growth has recovered from depressed levels to long-term average. Elsewhere in the world, Japan’s growth score has improved from -0.33 to +0.77 and the US from -0.84 to +0.05.
The growth score for Singapore deserves further explanation. Due to the larger statistical “noise” in its industrial production year-on-year series, we have modelled Singapore’s growth score on the 3-month moving average instead. Based on the “smoothed” metric, growth score for Singapore was -1.29 in September 2015 and has since improved to +0.08.
Note that a score of zero is NOT the same as 0% growth. It just means that current growth is at long-term historical average. For example, Singapore’s industrial production has a long-term historical average of +6.9% YOY. At +7.7% YOY, the latest 3-month average for Singapore’s industrial production is 0.8% higher than historical average.
What about global inflation? We deploy the same methodology on headline consumer price and retail price indices. As shown in Figure 3, inflation across countries has generally risen since September 2015. The exceptions are China (flat) and India (rapid declines). The general rebounds in inflation started from depressed levels, and inflation scores across economies are still largely below or close to their respective long-term averages. The greatest increase in inflation scores have been observed for the Eurozone (from -2.05 to -0.21) followed by the United Kingdom (-1.52 to +0.15) and US (-1.93 to -0.63). Indian inflation has been the notable exception as it went into reverse direction and declined from -0.80 to -1.66.
(# standard deviations from long-term mean since Jan-1982)
(# standard deviations from long-term mean since Jan-1982)
 Please refer here for more details.
 In the case of China, we use the “Lee Keqiang” index which is a weighted average of annual growth rates in outstanding bank loans (40%), electricity production (40%) and rail freight volume (20%).
 For Australia, we use the performance of manufacturing index (PMI) from the Australian Industry Group.