Keep an eye on the 10-year US Treasury yield

Date: February 19, 2018

Over the course of last week, the Straits Times Index gained 66 points or about 2 per cent at 3,44.51. This means that its 2018 gain is now 1.2 per cent, the entire amount coming on Thursday as it was flat for the year after Wednesday’s close.

The index’s rise on Thursday y came almost wholly courtesy of large gains in the three banks, led by OCBC, which jumped S$0.52 or 4.2% to S$12.78 with 7.4 million shares traded. UOB followed with a 3% rise and DBS, having already enjoyed ample support earlier in the week thanks to announcement of a generous dividend policy, added just 1%. Thanks to heavy trading in the three banks, turnover for Thursday’s half-day session was a very decent 1.1 billion units worth S$1 billion.

Providing the backdrop was Wall Street, which rose for five consecutive sessions up till Thursday. Investors should take note that US stocks rose during this period despite the release of two economic reports which suggested inflation, which for almost a decade has stayed low, is picking up.

The first was Wednesday’s consumer price index (CPI) which rose 1.8% year-on-year versus expectations of a 1.7% increase, and the second was Thursday’s producer price index (PPI) which rose 0.4% in January, higher than the expected 0.2%.

News reports quoted economists as saying that going by these and other reports such as those which have showed wages are increasing, higher inflation is here to stay. What this means is that the US Federal Reserve could be forced to raise interest rates more aggressively than the three the market is currently anticipating.

Here is where a problem arises. The selloff earlier this month came after reports that showed inflation could be a problem which led to suggestions that the Fed might tighten faster than anticipated. At that time, the 10-year US Treasury yield spiked up to 2.8 per cent, reportedly sparking off the selling.

Last week, the CPI and PPI reports pushed the 10-year yield even higher, to a 4-year high of 2.944 per cent. The 2-year yield rose to a 9-year high of 2.213% and yet stocks rose. Analysts have been quoted as saying this suggests that stocks can still thrive in a high interest rate environment, which if it to be believed, means that the market is returning to the “all news is good news for stocks”.

Our stance is that investors should be sceptical of this, be mindful of the return of complacency and think about whether such explanations make sense or whether they are based on convenience and momentum.

In this connection, asset managers Schroders made some interesting observations in its January Talking Point titled “Why three is the magic number for this year”.

“For 2018, “3” is the magic number for a reflationary environment to continue.

Growth: we expect global GDP growth to remain at roughly 3% over the next two years. Last quarter we highlighted the potential for the US Congress to surprise on tax reform and this has proved to be the case, but we would fade any fiscally-induced excitement at this point as we don’t expect US companies to fully spend the benefits of their tax cut.

US 10-year Treasury yield: based on our models, US equity valuations are sustainable as long as the US 10-year yield does not go above 3%. This would require inflation to remain subdued.

Inflation: as we believe that technological disruption and aging demographics are suppressing inflation, we expect an upper limit of “3%” to hold and for the process of monetary normalisation to be gradual. Against this backdrop, valuations become a speed limit for returns over the medium term but we think a period of lower returns is more likely than an imminent bear market.

As noted earlier, the 10-year yield is now very close to 3% so perhaps caution should be the watchword.

As for the local market, some of last week’s key events were:

1) News that the Indian stock exchange authorities will stop providing data for external index trading platforms. This means that the Singapore Exchange (SGX), which offers India equity derivatives, will be adversely affected. Although SGX issued a statement to reassure investors that it is looking at various solutions and that there will be material impact in its immediate financial results, its shares came under considerable pressure, plunging $0.58 or 7.4% last Monday to S$7.31 with almost 20 million traded. On Thursday, they closed at S$7.37.

2) The Ministry of Trade and Industry reported that the Singapore economy grew at a rate of 3.6% in 2017, led by a 10.1% expansion in manufacturing that came from the electronics and precision manufacturing clusters.

3) The three banks averaged net profit growth of 27% for 4Q 2017, bringing their combined profit for FY2017 to S$11.9 billion.

4) SGX queried Sembcorp Marine (SMM) last Monday for reasons why the latter’s stock price plunged S$0.32 to S$2.37. SMM replied that it could not explain the fall.

5) Singtel’s shares were weak, losing S$0.05 over the four days at S$3.33.

As always, the advice is to stick to the index stocks, for they enjoy the greatest analyst coverage and liquidity. Also, as the end of the month draws closer, watch for month-end “window dressing” or “portfolio rebalancing” that usually benefits mainly the index heavyweights.