Will there be an imminent market correction, and how will the Fed raising interest rates affect Asian equities?
After recovering from Tuesday’s year lows, an imminent correction for risk-friendly Asian equities is still on the cards as the uncertainty from the latest coronavirus variant’s economic impact and the U.S. Federal Reserve’s intention to exit monetary policy support earlier than thought will keep investors on edge into the year-end.
MSCI’s broadest index of Asia-Pacific shares outside Japan rose on Wednesday after hitting its lowest in a year on fears Omicron, the newly detected variant of coronavirus, would further disrupt the world economy, which is just about recovering from the pandemic paralysis.
“Starting with Omicron, markets saw a major reaction on 26th November after the news broke, with some of the biggest daily moves of the year so far taking place. Equities slumped across the world, bond yields fell back, and there were sharp swings in other asset classes too”, said Jim Reid, Head of Thematic Research at Deutsche Bank.
“For the time being, markets have reacted very negatively as governments have moved to tighten up restrictions once again”, Reid said.
While equities have reacted to good and bad news, market sentiment has veered towards the worst, with safe-haven sovereign bond yields moving generally lower.
The latest variant has inserted a new and, as yet, unsized risk premium into global asset markets, and despite some stabilisation, market sentiment is likely to remain shaky into the year-end, analysts said.
“There isn’t much scope for sentiment to improve before the end of the year. The bias towards pricing negative news was evident once again on Tuesday, and we expect markets, through the volatility, to continue trading with a downbeat tone”, noted Padhraic Garvey, Head of Research at ING.
The hawkish headlines from Fed Chair Jerome Powell, including comments on higher inflation and that it may be appropriate to conclude tapering a few months earlier, will only add to investors’ dull mood and bring forward expectations for rate hikes.
Asian and other emerging market equities will take a hit if Fed rate hike expectations solidify as higher U.S. interest rates generally push global investors to seek shelter in American assets in the search for higher returns.
Some may argue any economic damage from the new coronavirus variant, including renewed lockdowns, will likely dampen central banks’ desire to exit their extraordinary monetary support policies and, in turn, delay the expected rate hikes.
But Omicron is a near-term threat and will weigh heavily on equities, and higher inflation predictions are driving rate hike expectations.
The predicted timing for policy tightening is well into 2022. Those expectations are strengthening with views of more market participants turning into higher inflation for longer, which underscores the negative sentiment for Asian share markets.
“The Omicron variant and the winter wave underway in many countries do not subtract from inflation worries – they add to them. Gearing for hikes still makes considerable sense. Remember, the hikes are not expected to happen till the second half of 2022. By then, this latest Covid scare should be behind us”, noted ING’s Garvey.
“We don’t have enough to suggest that that should change, and in fact, Chair Powell has intimated that a closer scrutiny of inflation risks is warranted”, Garvey said.
On the economic front, the activity in Asian factories recovered in November, as supply bottlenecks eased somewhat.
Still, rising commodity costs and inflation, supply shortages, and fresh worries surrounding renewed lockdowns point to further strain on equity markets in the region.
No respite, despite diving deeper
Within Asian equities, the biggest losers from the pandemic, such as travel, leisure, financial, and energy shares, have rebounded this year compared to those stocks considered “lockdown winners”, which have lost momentum.
That market rotation has been a global phenomenon. But will it last?
The reality is many countries still face risks of renewed lockdowns from high COVID-19 infections, which will depress demand. As such, any run-up in those equity sectors hurt by the pandemic may well prove lacklustre, with a full recovery not expected anytime soon.
So, strategists broadly remain cautious across the board for equity markets in the region.
The one pandemic trend that is expected to continue in Asia is the rise of e-commerce, which has seen a deeper penetration as consumers have gotten addicted to the added convenience of these services. The quality and scope of these services are predicted to continue to improve.
Technology sectors, more generally, have also been winners this year from shifting consumer behaviour, and the optimism about the longer-term outlook for many of the main Asian players has been on the rise.
But a good 2021 for Asia equities has pushed up the valuations in some markets, suggesting a thorough stock selection approach is required going forward, while rising state involvement is likely to limit the attractiveness of Chinese shares in the near term.
“Asia ex-Japan equities had an eventful 2021. Chinese shares, in particular, faced several headwinds, and the ripple effects from these are likely to spill into 2022”, noted Toby Hudson, Head of Asian ex-Japan Equity Investments at Schroders.
“India offers opportunities but looks expensive. Sectors such as financials may benefit from higher inflation but face disruption from new entrants”, Hudson said.
Strategists expect Korean and Taiwanese markets to track the broader global cycle. While profitability across most of the tech sector remains very strong, they worry about a possible slowdown in 2022.
That is driven mainly by the view that some of the increased work-from-home demand for technology products may fade as people return to the office and be detrimental to related share prices.
Strategists suggest a relatively cautious approach for Southeast Asian stock markets, which are not particularly attractive because of the disruption faced by banks and traditional energy stocks from new financial technology and renewable energy.
“The parts of the stock market in Asia that do look cheap on headline multiples are sectors like banks, insurance, or property. These sectors are typically beneficiaries of higher inflation and interest rates, so may be opportunities for an improvement in returns in the medium term if inflation is more than just a ‘transitory’ issue”, noted Schroder’s Hudson.
These industries face ongoing structural challenges from the rise of fintech and e-commerce in the region, Hudson noted.
Overall, the Fed and Omicron tag-team is likely to drive broad sell-offs in Asian equities into the year-end.