After posting positive returns for 7 months straight, the global stock markets including the S&P 500 index have finally seen a correction in September. This is on the back of concerns of the Fed tapering and slowing growth, and the broader considerations on China policy risk including the vulnerable real estate and tech sectors. How have these market developments impacted investors and is there any need to take action?
0:00 Macroeconomic trends and outlook
05:42 Chinese regulation and real estate concerns
11:28 Tightening of monetary policy, inflationary pressures
15:30 Fixed income markets update
22:00 Endowus Core Advised portfolio returns
27:00 CPF and ESG portfolios performance
30:00 Outperforming robos
35:00 Cash Smart updates
43:00 Q4 and market outlook
53:08 China market outlook
57:43 Impact of interest rate increases
1:03:55 Diversification matters
Key excerpts from the webinar
Chinese regulation and real estate concerns (05:42)
Sam: China has been a meaningful detractor to performance not only in Asia and emerging markets, but also within sectors such as technology.
There has been a massive influx of liquidity into the equity markets globally, due to a loose monetary policy, quantitative easing measures, and individuals who invested their fiscal support monies. However, these flows have decreased sharply in the last quarter. When the market is climbing a wall of worry and earnings collapse, the price to earnings ratio increases - not because price has increased, but because earnings have collapsed during a massive crisis like the Covid-19 pandemic.
While the markets have actually gone up, their earnings recovery has meant that we have narrowed the earnings equity valuation gap, so that we are now one standard deviation above the long-term averages. If you use CAPE (the cyclically adjusted price-to-earnings ratio), we are about 1.4 standard deviations above the long-term average. Given that we were more than 2 standard deviations above the average during the tech bubble in 1999-2000, we are currently not at that stratospheric level yet.
Tightening of monetary policy, inflationary pressures (11:28)
Sam: Inflation is persistent because of supply chain bottlenecks. As such, we see a “gentle tightening” occurring, especially in interest rates and market yields. In such a scenario, equity markets will not necessarily do badly. Certain sectors, like the financial sector, could actually benefit from rising interest rates. The threshold at which equity markets tend to underperform is when the yield rises above 2-3%, and we are relatively far from that happening.
Both data points in the chart above - supply chain delivery times (left) and pressures on inflation from rising prices (right) - have dropped slightly from the peak, but are still at very elevated levels. This is still a concern, as it means that inflation is not going to come off quickly, hence posing a risk to policies and interest rates going forward.
Longer term view on tilts (14:12)
Sam: Endowus’s Core Advised portfolios contain tilts, as they are proven factors of returns over long periods of time.
The numbers still remain quite strong from a three-year rolling basis, with growth outperforming value. The performance of small caps have also started catching up with large caps. In the past one year and year-to-date, value and small have outperformed the rest fairly meaningfully.
Fixed income markets update (15:30)
Wei Mei: Across Q3, the 10-year US treasury yield has spiked up. The impact on fixed income portfolios as a consequence of having some duration risk would also be magnified due to this rapid increase in treasury yields.
In the Asian market, there is a fair amount of widening across investment grade and high yield spreads, because of the contagion that investors were concerned about coming out of China real estate. Overall, high yields would be more impacted as there is a general perception that default rates will continue increasing.
The US credit spreads have been more muted. Across the last quarter, levels did move up slightly, but they are well contained. This can present good buying opportunities for new investors interested in fixed income.
Fixed income valuations remain tight (19:51)
Wei Mei: Comparing levels today versus a 15-year average across all sectors, despite the recent widening we have witnessed in some markets, we still continue to be trading on the tighter end. This is due to default rates remaining low, and the markets being relatively bullish about overall fixed income performance.
Endowus Core Advised portfolio returns (22:00)
Read more on our in-depth Q3 performance review here.
Sam: After two stellar quarters of performance across all our portfolios, the numbers this quarter are surprisingly flat - most of them are zero or close to zero. Our 100% equities portfolio performance is -0.2%, comparable to the MSCI All Country World index return of -0.1%.
For factor returns in the developed markets, small again outperformed large for this quarter, year-to-date. Value has also outperformed growth.
For factor returns in the emerging markets, small and value outperformed large and growth.
CPF and ESG portfolios performance (27:00)
Sam: The CPF portfolio performance is also very flat. Equities did slightly better (-0.1%), while fixed income did slightly worse (0%). But both equities and fixed income did relatively well compared to the global benchmarks.
Sam: The stellar performer this quarter is our ESG portfolio. Equities generated 2.3% returns, which is relatively high compared to the benchmark indexes. Even fixed income, which traditionally has not been giving us strong returns, performed very well by generating a 0.2% return.
Endowus outperforming other robos (30:00)
Sam: This table is from an actual client who has accounts with Endowus and other popular robos. Being passive and strategic in our asset allocation has worked well for our clients, and we have very significantly beat our competitors in the robo space and against benchmarks.
One of the main reasons is because other robos have a relatively active asset allocation strategy. They constantly actively reallocate their portfolios’ assets, causing their performance to drag quite a bit.
This graph is from Investment Moats, tracking the performance of several robos over a year. Once again, the other robos have performed poorly in comparison to Endowus. Endowus’s passive strategic asset allocation gives you broad exposure to globally diversified markets and sectors, and this is the right way to invest for the long term.
Endowus Cash Smart updates (35:00)
Read our latest updates here.
Sam: The Cash Smart Ultra returns have been negative the past month (-0.27%), but across Q3, performance was still positive (0.11%). Generally, for longer time periods, Ultra does give you higher returns than Enhanced or Core, but that is starting to break down this quarter due to the rising interest rates and increased in volatility.
Referencing the chart above, Cash Smart Core has the lowest volatility, as reflected by the very steady line of virtually zero days of negative returns. If you are worried about volatility and want to protect your capital, yet at the same time generate much higher returns than saving your money in a bank, then Core is the way to go. If you decide on Cash Smart Enhanced or Ultra, you would be taking on more risks and volatility.
Sam: Only one fund - Nikko AM Shenton Income fund - out of the five that we have in the Ultra portfolio had negative returns, the other funds all had positive returns. The portfolio also has quite a lot of exposure in real estate, which has been heavily impacted (e.g., Evergrande and Huarong in China), hence dragging down the performance of the portfolio.
However, we also realise that this is a short mark to market return, and returns could recover very quickly if the China real estate sector rebounds, or if interest rates start moving in the reverse direction.
There is also an upside to rising interest rates. These short term mark to market losses are not realised if you hold onto your portfolio. Most short term income and short duration funds would hold all of their fixed income and bonds to maturity, which means that you will get back the original par value, and mitigate any mark to market losses.
Q4 2021 and market outlook (43:00)
Wei Mei: Broadly speaking, across different indicators - economic activity, inflation, and monetary policy - it is clear that we are in the mid-cycle of recovery.
In terms of economic activity, supply chains continue to have difficulty in delivering goods, but there is a lot more normalcy that’s coming back with more of the economies across the world opening up.
The key question regarding inflation is whether it is going to be persistent or transient. The Fed is expecting it to be transient, and that it would normalize in 2022. However, increasing energy prices might cause inflation to be more persistent than what the central banks are expecting.
An institutional fund manager survey of over 280 participants done by Bank of America found that institutional fund managers continue to consider inflation to be the biggest tail risk in suppressing growth. China is considered the second largest tail risk.
With the Fed’s expected tapering announcement in November, most of the institutional fund managers are expecting higher volatility (higher VIX index), a stronger dollar, and higher credit spreads.
From the most recent September FOMC meeting, tapering is expected to start around November. The first rate hike should be coming in at 25 basis points. The Fed officials are divided on if they should begin raising the Fed Funds Rate by end 2022, but the overall consensus is for it to happen in Q4 of 2022. But as always, you should be anticipating that the market will price in a rate hike before it actually happens. So when the rate hike actually happens, there is a higher probability that markets will rally and fixed income funds will recover.
China market outlook (53:08)
Wei Mei: The Chinese government seems to be running on a twin engine of both a loose monetary policy as well as fiscal stimulus. The Bank of China will add liquidity into the market to help support growth, and is prepared to continue to carry on having a fiscal deficit to be able to boost the economy.
While some people might want to avoid investing in China during this period, it is not wise to do so, since China has a very high weightage in many indexes, for example the MSCI Emerging Market index (where China has 38% exposure in 2021).
Given the aggressive sell-offs that have been happening, the market has already priced in a much higher default rate. As seen from the graph, there is a large percentage of bonds that are trading below 50cents to the dollar, and this number has doubled since one quarter ago. For more opportunistic investors, investing in the China market now might be beneficial.
Impact of interest rate increases (57:43)
Wei Mei: Year-to-date, in terms of returns, we see that convertibles, US high yields, and floating-rate securities have generated positive returns. The 10-year US treasury rate increase does not necessarily affect all sectors, and it will be a sweeping generalization if we think that we should exit fixed income altogether.
There is a difference between price return and total return. Price return is effectively capital gain or loss without coupons or dividends. Total returns takes into account both capital gains and the income generated from coupons and dividends, making it a better metric than price returns. This is also why bonds with a higher coupon will tend to outperform those with lower coupon rates.
We can continue to expect equities to outperform as interest rates increase, but only up till a reasonable increase in interest rates. As long as interest rates rise up to a maximum of 3.6%, this correlation pattern should hold, and equities should continue to generate positive performance.
Diversification matters (1:03:55)
Wei Mei: Being broadly allocated to different sectors can help you stay diversified and cushion market volatility. From the chart above, the S&P 500 declined the most and took the longest to recover, while the 40-60 and 60-40 portfolios recovered much earlier.
If we look back on a 20-year time horizon, it is very difficult for an average investor to outperform the market, so it is much better to stick to a strategic asset allocation. If you held a 40-60 or 60-40 portfolio, you would have generated much higher returns compared to the average investor. It is thus important that you keep to your long-term objective, and not let short-term market volatility tempt you to make changes to your long-term asset allocation strategy. Even now, you should not suddenly reallocate your assets, unless your personal circumstances have changed drastically.
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