Wealth Insights (April 2017)

A change in tune post Fed meeting in mid-March?

Johan Jooste
Chief Investment Officer
Bank of Singapore
Member of OCBC Wealth Panel

In the few days after the last Fed meeting mid-March, U.S. equities did not really budge one way or another, until late March when concerns about whether Trump would get enough Congressional support for his policies caused a pull back on Wall Street.

Apart from the Fed’s comparatively dovish remarks, the market has been devoid of serious news: the Dutch election was a non-event and nothing else has succeeded in disturbing the peace.

In other markets than stocks, the reaction has been a bit more marked. First, the drop in the oil has had a noticeable effect in the high yield bond market. As oil drifts towards US$45 per barrel, the market is quick to remember the energy sector’s near-death experience when the market was last at these levels. The reason is of course that the U.S. high yield sector is heavily represented by oil and energy bonds: somewhere in the region of 15 per cent at last count.

So, it makes sense for the market to express caution by forcing spreads higher. Is this the sign of broader systemic fears or is it a temporary blip?

First, the drop in the oil price this time around is still pretty modest by the standards of the previous collapse from over US$100 per barrel to US$40. Second, survival of the fittest has already taken care of the problem to a significant degree: a large number of issuers that were not up to operating in a weak oil-price environment have already gone down the chapter 11 route. Third, the global backdrop of solid growth should provide support for oil demand, even if recent indicators of inventories hint at a mini-glut.

Despite these factors, mutual fund flows have been outwards in big volume. Our initial assessment is that the move is overdone. Credit as an overall asset arguably benefits more directly from strong underlying growth than equities. Equity markets have high growth expectations to live up to; bonds only have to remain creditworthy. That is much less of a challenge in a benign economic environment. We thus remain confident in our call to hold high yield bonds.

It should also be the case that any short-term wobbles in Emerging Markets will turn out to be just that: short-term. For the immediate future, there are enough economic tailwinds around to make a sudden change in fortune unlikely.

Also of note post-Fed has been the slip in fortunes of the U.S. dollar against the majors. As we indicated a while ago, the idea was that the dollar was running out of steam somewhat after a surge after the U.S. elections. The more dovish tone of the Fed has reinforced this move. While we are not changing the call on the dollar yet, it is instructive to keep an eye on developments in this market to read broader risk sentiment.

Not all equity markets stand to do well if the dollar falters, even for a while. The Nikkei would be the first to come under pressure. The broader risk-on rally itself may also be at risk, given that to date a strong U.S. equity market has been accompanied by a strong dollar. Ultimately the view will boil down to an opinion on Fed policy. Given the recent growth performance there is the risk that the Fed may be erring on the side of being too dovish. A more convincing argument for a moderation of equity performance is stretched valuations, not a dive in the value for the dollar.