After a tumultuous start to 2023, we advice investors to be nimble
The first six months of 2023 have been tumultuous, characterized by a divergence of global economic trends, monetary policies and market direction. Despite aggressive monetary tightening compounded by the regional banking crisis and the debt ceiling saga, the US economy has shown resilience. On the other hand, China’s growth slipped after a positive first quarter GDP surprise, spurring a fresh round of rate cuts by the PBoC since June. Against this volatile backdrop, the US equity markets staged a dramatic turnaround, up double digits in the first half of the year, whereas the MSCI China Index fell by mid-single digits.
Looking ahead, amidst the undercurrents facing the macro environment, we advise investors to be nimble and stay CALM, namely to Capitalize on market opportunities, Allocate broadly, Lean to Asia, and Manage volatility. We see risks of a US recession in the next 12 months, albeit delayed into the first half of 2024 and less severe than our prior forecast.
Why invest in fixed income when cash enjoys high fixed deposit rates?
Though timing of a US recession is uncertain, we believe we are approaching the peak of the US interest rate hike cycle. We compared the performance of the long-tenor US government bonds with that of cash during the two-year period ensuing the final rate hike in each of the last three rate hike cycles. The high quality government bonds produced an average return of over 17%, outperforming cash by 9%.
At this juncture, when yields have more room for downside (i.e. bond prices to go up) than upside post the recent surge, we prefer quality government bonds to cash here, as fixed deposits are subject to reinvestment risk – that is the risk that when the deposit matures, the reinvestment rates are much lower. Apart from weathering a potential recession with limited credit risk, US government bonds allow investors to clip decent coupons, while providing exposure to bond price appreciation should yields moderate.
Lean to Asia
In terms of risk assets, Asia including Japan presents an interesting risk-reward proposition. As a stark contrast to US equities, where valuations look comparatively stretched, both Japan and the rest of Asia trade at a discount to global equities, while possessing a superior earnings growth outlook. Japan‘s earnings growth is benefitting from an improving economic outlook and accelerating stock buybacks. With the Topix up 20% year to date, is it too late to add Japan? We don‘t think so, but it is becoming more important to be selective. One sector we favour is Japan financials, which has been a laggard in sympathy with the US regional banking crisis. As their accounting practices are more conservative, the banks in Japan will likely benefit from better loan growth and improved corporate governance. As for the rest of Asia, we expect double-digit earnings growth this year from the two most populous economies – China and India.
Stay patient with China
Though retail sales growth in China came in short of expectations in April/May, we anticipate targeted fiscal policy support to emerge from the Politburo meeting in July, with a view to reviving confidence and lowering unemployment. This augurs well for sectors such as consumer discretionary and communication services. We recommend a balanced positioning between onshore and offshore China equities. Within onshore China equities, we find greater exposures to high-end industrials, software and semiconductors, which are the focal areas of policy support to drive digital transformation. Offshore equities encompass beaten-down platform economies and state-owned enterprise (SOE) in H shares with discounts to their A-share equivalents and attractive dividend yields.
Why India, Taiwan and Korea look interesting
Ongoing U.S.-China tensions and domestic policy uncertainty will keep a lid on sentiment towards China equities, but diversification into Asia excluding Japan provides a counteracting mechanism. India plays a good natural hedge against the China risk. Its improved fiscal position, restructured banking systems, and infrastructure investment growth will benefit most domestic sectors, including financials and industrials. The earnings growth outlook is promising enough to mitigate the risk of its valuation premium, in our view. Furthermore, Korea and Taiwan equities are interesting as they have large representations from the semiconductor sector, which is starting to gradually recover from the downcycle due to excess inventories. Some of these names are cheap proxies for AI exposures.
Diversification and managing volatility
Apart from geographic diversification, allocating to asset classes like liquid alternatives (e.g. hedge funds) and private assets will enhance risk-adjusted returns against choppy market conditions. Gold is also an important portfolio ballast, as geopolitical risks remain elevated and many Emerging Market central banks plan to shore up their reserve mix in gold. Equity volatility is at suppressed levels and slated to increase, in our view, providing us with an opportunity to monetize through structures. We recommend balancing defensive positioning by adding quality growth exposures on pullback.
In sum, as our view is that the U.S. recession will be delayed to the first half of 2024, maintaining a diversified investment portfolio across growth and income exposures is an effective approach to participating in secular growth and securing yields against current uncertain times.
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