Peak valuations and monetary tightening means that investors need to stay defensive. We don’t see a big correction in the near-term but it also doesn’t make sense to chase the market rally aggressively.

Marc Van de Walle, Head, Group Wealth Management, OCBC Bank

O C T O B E R 2 0 1 7 I S S U EMONTHLY ECONOMICS NEWSLETTER

In This IssueGLOBAL OUTLOOK Focus on debt P.2

If you have any queries on investment products, please call our Customer Services Hotline on 3199 9182 or visit our website at www.ocbcwhhk.com.

HONG KONG / CHINA MARKET OUTLOOK Be selective P.3

EQUITIES Cautious outlook P.4

BONDS Expect slower returns P.5

FX & COMMODITIES Headwinds for gold P.6

SPECIALS Local Rates To Rise Slowly P.7

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Stay Defensive

“ ”

Entering Uncharted Waters

”Focus on debt

Tighter monetary policy and credit conditions will bring the focus onto the build-up in global debt, which has risen from under 180 per cent of GDP before the global �nancial crisis, to 220 per cent of GDP.

Richard Jerram, Chief Economist, Bank of Singapore

GLOBAL OUTLOOK

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“Key Points • Higher interest rates along with tighter monetary policy could worry markets and investors because global debt has increased significantly

in the past eight to nine years.• The rise in debt in developed markets is entirely due to government borrowing. Most of that came in the immediate aftermath of the

global �nancial crisis, as governments tried to boost growth and repair the �nancial system. Following �scal austerity, debt levels have been roughly stable for the past �ve years. Considering the lengthy maturity of government debt, a gradual rise in short-term interest rates should not cause many problems.

• Private sector debt has fallen (relative to GDP) in developed markets, as a result of improved household finances. This contrasts with the build-up that contributed to the Global Financial Crisis (GFC). Corporate sector debt has been stable, although that might conceal the potential for stress in some sectors.

• Second, the rise in debt in emerging markets is primarily due to China, because the economy has become so large and the debt has grown so rapidly that it overwhelms the rest. Debt in China is up from 146 per cent of GDP, to 258 per cent over the past decade; all other emerging markets from 109 per cent to 137 per cent.

• China’s debt build-up is very worrisome and threatens domestic disruption, but is mainly internal and not particularly exposed to tighter global monetary conditions. Some other emerging markets might struggle as developed economy monetary policy tightens, but even compared to the “taper tantrum” of 2013, most look more solid structurally, and external deficits are smaller.

• As a result, gradual monetary tightening across many developed markets should not involve too many problems for global growth. Howev-er, after a decade of ever-looser policy it could produce a di�erent environment for investing.

• Hurricanes will distort U.S. economic data for the next few months, but natural disasters rarely have lasting impact on large, rich countries.• The U.S. economy is at a relatively mature stage in the cycle but so far is showing few signs of upwards pressure in wages or consumer

prices. Recent slippage in inflation is hard to explain, and is likely to be short-lived, considering the tightness in labour markets. • Political chaos continues, but self-interest might still deliver a corporate tax cut. At least the immediate risk of government shutdown or

default has been pushed out, until year-end or beyond. Despite the aggressive rhetoric, the absence of material trade protectionism compensates for the lack of progress on economic reforms.

• Growth in Europe remains impressively solid, even as the stronger exchange rate should be a drag on the export sector. PMIs are still around the best level since 2011, while GDP growth this year is set to be the strongest in a decade.

• The end of fiscal tightening has combined with the benefits of post-crisis structural reforms and a more healthy financial system that is improving the effectiveness of monetary policy. A side benefit of the stronger growth is a reduction in support for populist politics, with a busy election calendar bringing no upsets in 2017.

• The Bank of England is in a difficult position, with inflation running well-above target, while signs are starting to emerge of damage from Brexit. It looks ready to reverse the 0.25% interest rate cut that immediately followed the Brexit vote in June 2016 and will then probably take a wait-and-see approach. Lack of progress in discussions with the EU suggests the risk of material short-term damage from leaving, especially if there is no interim agreement to preserve preferential access to the European market.

• Another round of elections is unlikely to produce any policy change in Japan. Prime Minister Shinto Abe’s popularity has recovered after some low-grade scandals, and the disarray of the opposition offers the opportunity to extend the government’s term in office.

• Abe is not asking for a mandate for more aggressive economic reforms, although he is seeking approval for the next step up in the consumption tax, to 10 per cent. Cyclically, the economy is in good shape, with the lowest unemployment rate in a generation, while neces-sary structural reforms – particularly related to the labour market – continue to look difficult.

• Growth in China has slowed in response to a squeeze on the housing market and credit growth, but the deceleration is very moderate. Debt is still rising as a proportion of GDP, but at a slower pace than in recent years, lending hope to the idea that reforms aimed at controlling the credit bubble are gaining some traction.

• We might see pressure on some deficit countries as U.S. interest rates continue to rise, as the cost of attracting capital will become more expensive. However, this does not seem likely to become a systemic problem.

Be selective

Key Points • The once in five years National Congress of the Communist Party of China (CPC) will be held in October 2017. While it has

important implications from political perspective with expectations of significant changes among the leadership team, major changes from the economic perspective are not expected.

• With key government officials and new leadership team in place post event, we expect it will help reaffirm the continuation and implementation of certain reform agenda such as the State-owned Enterprise reform, including mixed ownership reform.

• While economic growth is expected to moderate in 2H2017, domestic liquidity and policies will likely stay accommodative to support stable economic growth with stability remaining as the top priority.

• MSCI China performance was largely flat in September, in-line with the broad regional market, as investors took profit ahead of China’s Golden Week long holiday.

• The market is not cheap trading at 14.7x PE, more than 2 standard deviations above 5-year average, though earnings growth expectations remain robust based on consensus estimates.

• Recent share price pull back in certain sectors offer selective opportunities despite our neutral market stance.

• After some 30 per cent rally in 3Q2017, Chinese property sector has recently undergone profit taking pressure amid recent tightening measures in six tier-2/3 cities. While we do not rule out the possibility of further policy measures to be introduced in selected cities, demand has remained resilient for the 18 tier-1/2 cities that have introduced tightening measures on reselling since March-April this year.

Recent share price pull back in certain sectors o�er selective opportunities despite our neutral market stance. Economic growth is expected to moderate in 2H2017, domestic liquidity and policies will likely stay accommodative to support stable economic growth with stability remaining as the top priority.

HONG KONG / CHINA MARKET OUTLOOK

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Cautious outlookWe remain cautious on the outlook for global equities in view of the tightening global monetary policy environment driven by the impending unprecedented central bank unwinding and potential U.S. rate hikes.

Sean Quek, Head Equity Research, Bank of Singapore

EQUITIES

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“ ”Key Points • Equities rode on the steady global growth outlook and resilient investor con�dence in September, even as geopolitical risks

threatened to derail the on-going recovery. Global growth outlook, led by Europe, continued to impress. However, growth momentum in China has slowed although the deceleration is still moderate.

• Subsequent to the Fed’s plan to unwind their balance sheet, the European Central Bank is set to announce Quantitative Easing tapering plans in 1H2018. In view of the tightening global monetary policy environment driven by the impending unprecedented central bank unwinding and potential U.S. rate hikes, even as overall growth prospects seem to have peaked, we remain cautious.

• Also extended valuations provide limited support. We continue to prefer the U.S. and Europe over Japan and Asia ex-Japan.

• Having announced the gradual unwind of their US$4.5 trillion balance sheet, Fed officials are now debating on whether inflation will firm enough for them to raise interest rates a third time in 2017. Inflation has remained below target, even as the U.S. unemployment rate has fallen.

• The easing in U.S. financial conditions supports a more positive growth outlook but also more hawkish stance. Hopes for fiscal stimulus driven boost continued to fade with the most recent e�ort to overhaul the healthcare system on life support and a Republican tax proposal still lacking details.

• Nevertheless, according to a University of Michigan survey, small investors have never been this bullish. Consensus 2017 EPS outlook has been relatively stable. Given our overall cautious view, U.S. equities remain more defensive.

• Benefiting from further signs of growth recovery and a slightly weaker EUR, consensus EPS for Europe continued to pick up - after deteriorating steadily since peaking in May. The improving macroeconomic outlook means that pressure for the central bank to start phasing out its quantitative easing would intensify.

• Near-term, financial market movements could still be dictated by clues on the European Central Bank’s (ECB’s) next move. We see a less dovish central bank as the economic recovery continues to gain pace.

• We maintain a neutral stance here.

• Japanese equities benefitted from talks of a potential snap election. Despite the euphoria, the latest move by Prime Minister Abe is not expected to result in major policy changes.

• Near-term, the economy is in a decent state but sustained re-rating of the market would require more meaningful structural reform to boost overall growth. Hence, besides politics, we see macro factors and movements of the JPY to remain key drivers for the market.

• North Korea and Trump’s spat continued to propel geopolitical risks for the region although investors seem increasingly nonchalant. South Korea, together with the Philippines, led the winners in September. Taiwan and India were the biggest laggards.

• China, still the best performing market so far this year, came under selling pressure as policymakers unexpectedly stepped in to reign in �nancial risks ahead of the leadership reshu�e at the 5-yearly party congress. Valuations for the region are now looking stretched as the rally extends.

• Even as the markets remain sanguine on the North Korea hostility, other macro risk factors, such as the trade war risk between China and the U.S. and potential impact of the unprecedented central bank unwinding further ahead, lurk.

• We expect investors to take a wait-and-see attitude ahead of the next set of corporate earnings releases. With the recent consolidation, selective accumulation opportunities have opened up. Our advice to rotate into stock ideas with stronger fundamental support is maintained as we head into the last quarter of the year.

Expect slower returnsBONDS

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“ ”Key Points • Monetary policy tightening, in the form of interest rate hikes and smaller central bank balance sheets will spread from North America

to a range of other developed economies over the coming year, as economies continue to heal the wounds from the Global Financial Crisis (GFC). The process will be gradual, but it represents a significant change in direction after the ever-looser policy environment of the past decade. This will have implications for bond markets.

• Overall, we still see selective opportunities in bond markets but returns will not be as strong as in the past. With spreads close to all-time tights, we expect modest spread tightening. As a result, coupon income will likely drive asset class performance. We recommend reducing overall portfolio duration and a move up in credit quality to reduce risk.

• The Fed does not seem distracted from its intention to slowly normalise monetary policy as it continues to project four more interest rate hikes by the end of 2018. This is in line with our expectations, with the next move coming in December. Balance sheet shrinkage begins in October, but it has been well-signalled and should not be disruptive.

• The Fed’s process to shrink its US$4.5 trillion balance sheet from October will be gradual, starting at US$10 billion per month and rising to US$50 billion by the end of 2018. At this pace, normalisation will take around four years and the overall G3 balance sheet is set to start to shrinking in 3Q 2018.

• However, the Fed’s unchanged intention of raising interest rates four more times by the end of 2018 was more notable, as some policy-makers had expressed concern about the recent slip in inflation. This has been puzzling, but is likely to be short-lived, with the unemployment rate below normal levels.

• In late October, the European Central Bank is set to announce plans to reduce asset purchases in 1H 2018, and could hike rates by end 2018 (together with Switzerland). As with the Fed back in 2014, reducing monetary support to reflect a stronger economy should not cause many problems.

• Japan’s inflation remains a long way from the 2 per cent target so a policy shift is still far in the future. Short-term interest rates will remain at -0.1 per cent and bond yields are targeted at around zero for most, if not all, of 2018.

• Monetary policy continuity is likely to be evident when Bank of Japan Governor Kuroda’s term expires in six months, and if he is not re-appointed, his replacement is expected to be just as dovish.

We see more reasons to be selective within corporate bond markets than we did at the beginning of the year, as credit spreads are tight and returns are likely to be more muted compared with the recent past.

Vasu Menon, Senior Investment Strategist, Wealth Management Singapore, OCBC Bank

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Headwinds for goldFX & COMMODITIES

“ ”Support for gold from flight to quality and the maturing U.S. Dollar cycle will likely be increasingly challenged, as more developed central banks join the Fed in heading towards tighter monetary policy.

Michael Tan, Senior Investment Counsellor, OCBC Bank

Key Points • The newfound love for gold may increasingly be challenged by the gradually changing market backdrop of rising global rates. First,

the September Federal Open Market Committee meeting revealed a steady consensus around a December rate hike. Going forward, downside U.S. inflation surprises are likely behind us and normalising inflation is set to drive U.S. rates higher.

• Second, and more importantly, tightening policy seems to be back in fashion and it is not only about the Fed. Many central banks in advanced countries have swung to a more hawkish stance, likely encouraged by more the solid tone to global growth and stronger equities. The most important change in policy is likely to come from the European Central Bank in October.

• Over the medium-term, as global rates start to further inch up, we expect gold to rebase lower.

• Concerns about geopolitical events disrupting supply have given a boost to oil prices, but this is likely to be short-lived. U.S. shale drilling has levelled o� in recent weeks, but activity would soon step up if higher prices create the right incentives. Demand growth is solid, but not picking up to any meaningful degree.

• After the bottoming out in September, the question is will the U.S. Dollar finally turn the corner by strengthening in 4Q2017, after its year-to-date slide? We think this will have to be predicated by a sustained breach of key technical levels across a range of asset prices, including U.S. Dollar index (DXY), 10-year U.S. Treasury yields and Bund yields.

• As we step into October, the greenback may retain the upper hand against the Euro (political and European Central Bank uncertainty), the Australian Dollar, the Canadian Dollar and the Japanese yen (still sufficiently dovish central bank plus political uncertainty). The Pound (Brexit overhang) and the New Zealand Dollar (political uncertainty, sufficiently dovish RBNZ) could also lose some of their shine against the greenback.

• Looking further ahead, we think that the Fed is not the only central bank that could tighten policy in the coming months. Given the Fed’s relative con�dence of its prognosis in September, other major global central banks may also turn less dovish or even more hawkish. This shifting relative central bank dynamics may eventually hurt the U.S. Dollar.

• The nominal effective exchange rate (NEER) has continued to persist in the upper half of its perceived fluctuation band, although excessive Singapore Dollar outperformance remains in check.

• To this end, we look for Singapore Dollar outperformance against the Euro, Australian Dollar, and the Canadian Dollar, while the Singapore Dollar may lag the Pound as the BOE surprises with its hawkish stance again. Elsewhere, we expect the Singapore Dollar to be range bound against the New Zealand Dollar.

Due to fears of more bill sales plans by HKMA ahead, the rising expectations for a third Fed rate hike and the huge funding demand associated with the IPO deal, HIBOR jumped notably from 0.425 per cent to 0.549 per cent within one week. However, the sharp rise in HIBOR may not be sustainable. Any retreat in HIBOR will support the return of carry trade and drive the HKD down towards 7.82 against the USD. Elsewhere, the expected housing correction may be moderate amid slow rise in HKD rates.

Treasury Research, Treasury Division, OCBC Wing Hang

Local interest rates to rise slowlySPECIALS

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“”Key Points

• Though the U.S. Federal Reserve has raised rates three times so far this year, HK Dollar rates still remained at a multi-year low due to ample liquidity. Continuous equity in�ows and strong foreign investment in the housing market have contributed to the pilling up of interbank liquidity. This fuelled speculation on a wide yield differential between the U.S. Dollar and the HK Dollar, even pushing the HK Dollar towards 7.83 against the greenback at one point. As a result, the Hong Kong Monetary Authority (HKMA) was prompted to announce two bill sales plans - totalling HK$80 billion - in August and September, in order to mop up the abundant liquidity.

• After the second batch of bill sales plan was announced, the market was concerned that the HKMA may continue to drain cash from the banking system. Together with rising expectations that the Fed will raise rates again this year and funding demand associated with the upcoming mega IPO deal, 1-month HIBOR jumped from 0.425 per cent to 0.549 per cent within one week.

• However, even after the second round of bill sales, aggregate balance may still remain sizeable at around HK$180 billion. Therefore, after the end of 3Q2017, HK Dollar rates are expected to retreat slightly amid flushed liquidity and in turn reinforce market expectations on a wide yield differential. Therefore, we expect any rally in the Hong Kong Dollar to be unsustainable, as investors are likely to buy USD/HKD on dips.

• HKMA also stated that “interest rate gap may suppress HK Dollar down to 7.85 against the U.S. Dollar”. As such, the HKMA is likely to issue more Exchange Fund Bills in the future and allow the HK Dollar to find strong support before 7.8250 against the U.S. Dollar. In fact, the HKMA announced four EFBs sale plans per year over the past two years.

• Some may be concerned that more bill sales by the HKMA will reduce interbank liquidity and push HK Dollar rates higher, which therefore would hit the housing market. However, we expect further moves by the HKMA’s to merely add moderate upward pressure onto the HIBOR. Whether HIBOR would catch up with LIBOR at a faster rate depends very much on the Fed’s rate hike pace.

• Should the Fed proceed with a third rate hike in December, 3-month HIBOR is expected to approach 1 per cent by year end. Still, the rise in HK Dollar rates is expected to be relatively slow. If this is the case, housing correction is likely to remain moderate (housing transactions dropped for the second straight month by 31 per cent YoY in August while overall property price index softened on a yearly basis for the first time since June 2016).

• Moving forward, if the Fed raises rates three times and expands the size of balance sheet reduction as scheduled in 2018, capital may gradually flow out of Hong Kong and in turn bring the HIBOR up further in the medium term. A resultant narrowing of yield di�erential may ease some downward pressure on the HK Dollar.

• On the other hand, though higher rates, increasing supply, cooling measures and the curbed overseas investment of Chinese property developers are likely to ease momentum in the housing market, a stable labour market is likely to weather part of the impact, in turn shielding the housing market from a collapse.

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