One alternative to investors would normally be extending the tenor of investments, assuming that they have the appetite to invest over the longer term, by investing in bond markets. However, the environment for global bonds is not positive and we expect meagre returns over the next 12 months, given high or rising inflation and deteriorating fiscal dynamics, especially in the West.
Singapore bonds are unlikely to significantly outperform their global counterparts as we expect the interest paid to be largely offset by capital losses as yields rise.
Consider equities - look at dividend yield, watch for risks to PER and earnings growth
Until recently, the good news has been that a relatively small allocation to global equity markets would have offset the inflation erosion from investing in cash instruments.
The MSCI World index rose 31 per cent in 2009 and then over 10 per cent last year. In the first quarter of this year, the return has been almost 4 per cent (over 16 per cent on an annualised basis). This performance was remarkable given the backdrop of much higher oil prices, due to the political crises in the Middle East, the earthquake, tsunami and radiation leak in Japan, the sovereign debt issue in Europe and increasing signs that the Asia rate hiking cycle may be more severe than expected.
Given the low returns expected in other major asset classes (cash and bonds), we remain overweight on global equities on a 12-month time horizon. However, the outsized returns we have seen over the past 27 months are unlikely to be replicated going forward.
There are three key drivers to equity market performance:
The dividend yield, earnings growth and the price-earnings ratio (PER, the price the market is willing to pay for earnings). We see little reason to forecast a significant re-rating of equity markets via a higher PER in the coming months, as the risk of higher oil prices remains. Our analysis suggests if oil prices rise to around US$150 per barrel on a sustained basis, it would significantly undermine global growth, reducing the attractiveness of global equities.
Therefore, we are likely to have to rely on the other two factors to generate the majority of returns. The MSCI World index dividend yield is 2.4 per cent currently, while consensus earnings growth is around 14 per cent on average over the next two years, according to I/B/E/S data.
However, earnings growth could disappoint as companies take the hit, at least initially, from higher food and oil prices. Therefore, we estimate that equities are likely to generate more normal high single-/low double-digit returns over the next 12 months.
With cash and bond returns being abnormally low, we believe this still warrants a small overweight for global equities on a 12-month basis. For those willing to ride out short-term volatility generated by the tightening cycle, we expect Asia ex-Japan equities to outperform over a 12-month time horizon.
A continued global economic recovery remains our central scenario and this is positive for Singapore companies. However, Singapore is one of the countries most exposed to potential supply chain issues after the earthquake and tsunami in Japan. Therefore, the earnings of some companies in the first half of the year may be adversely affected, but this will be short-term.
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