Stay CALM, allocate broadly

Written by Rajat Bhattacharya , Senior Investment Strategist at 渣打银行

The ongoing market selloff is a reminder of the risks confronting investors after equities climbed vertically this year. Continued weak sentiment in China, rising US Treasury yields and a rebound in the USD – all came to a head this month. Our CALM framework highlighted in our H2 Outlook is more salient in the current market turbulence.

A is perhaps the most significant letter in this framework.

It stands for ‘Allocating broadly’ – maintaining a diversified and balanced foundation allocation should help mitigate volatility, especially during such times.

Near-term volatility

A month ago, our investor positioning and sentiment indicators flagged risks in the red-hot US technology sector, which has been leading the equity market rally this year. Subsequently, Fitch’s downgrade of US’s debt rating and US Treasury’s guidance of a surge in bond issuance returned focus on the impact of soaring US fiscal deficit on market liquidity.

Add to that resilient US data and still-hawkish central banks, and the stage was set for the 10-year US Treasury yield to retest last year’s cycle highs just above 4.3%. Moody’s downgrade of some US banks is a reminder of the risks in the US regional banking sector (first flagged in March) due to its exposure to office properties and asset-liability mismatches from falling prices of government bond holdings.

Challenges in Asia

The current downturn has challenged the L in CALM, which stands for ‘Lean towards Asia’.

While we remain constructive on Japan (last week’s strong GDP data supports this view), China’s sustained weakness is testing our preference for the broader region. Concerns about missed payments by major property and trust companies have added to the uncertainty. Investors are looking for more significant and sustained support from policymakers to revive confidence. Until then, we will need to see key technical support levels hold before wading back to the market. For the Hang Seng index, the next big support is at 16,800.

The opportunities

While weak seasonality (September is seasonally weak for equities) and technical charts point to more near-term downside, further weakness would present opportunities for medium-to-long-term investors.

The C in CALM stands for ‘capitalising on market opportunities’

The latest turn in the market mood is a reminder that markets often outrun fundamentals, on both directions. The surge in Developed Market government bond yields and consolidation in Indian equities are good examples.?

The lure of government bonds

The US 10-year Treasury yield is testing last year’s cycle high just above 4.3%, offering attractive risk-reward odds for investors. Even if the yield rises to new cycle highs closer to US trend nominal GDP growth (the typical peak for the US 10-year yield) just above 4.5%, bond investors will earn positive 12-month total returns. Meanwhile, investors owning a 10-year bond would gain significantly more if yields fall as growth slows over a 6-12-month horizon.

Structural case for India

The pullback in Indian equities makes them attractive for investors structurally under-allocated to the market. Indian equities have consistently delivered over the past 20 years (see table), rivalling other stellar performers, such as the US. This is driven by positive earnings growth potential and high return on equity.

Even though the market remains relatively expensive and there is risk of near-term volatility, these factors also make a case to have a higher allocation to India in global structural portfolios than that prescribed by benchmarks. Meanwhile, Indian government bonds offer attractive real returns, with relatively low volatility.

Finally, the M in CALM stands for managing volatility.

We see attractive opportunities in the US healthcare sector due to its defensive qualities during a downturn. The sector’s resilience during last week’s selloff supports this view. Gold also offers portfolio diversification benefits, especially in volatile markets. We see strong technical support around USD 1,812/oz.