Global Market Outlook

Reshuffling after the pause

• Major central banks are now likely on pause as they gauge the impact of their extraordinarily rapid series of rate hikes amid a mixed bag of economic data. We believe this favours taking selective region, sector and credit quality risks.

• We upgrade US equities at the expense of European equities on the back of relative growth resilience. Developed Market (DM) bonds continue to offer an attractive risk/reward, with current yields creating a sizeable buffer.

• We trim Asia ex-Japan equities and Asia USD bonds to core holdings, as a catalyst for more significant Chinese policy stimulus is absent. In Asia, we retain our Japan equities Overweight and prefer diversified exposure across markets within Asia ex-Japan. We upgrade Emerging Market (EM) local currency bonds to Overweight.

Wait-and-watch policy ahead?

Financial markets have had a circumspect Q3. Major equity and corporate bond markets witnessed wide ranges, but are now back largely at end-Q2 levels. Strong Japanese equity market gains, the rise in US government bond yields and the surge in oil prices have been key exceptions.

This market picture is likely a result of an intense investor debate reflected in the recent macroeconomic data. The US economy is balancing still-strong consumer spending and a very nascent bottoming of manufacturing against very weak leading economic indicators, still-elevated inflation and tight financial conditions. Europe is facing a manufacturing slump and a weakening services sector, the strong job market notwithstanding. Chinese growth remains under pressure from property sector woes, though some macro green shoots have been emerging.

Against this backdrop, we are of the view that major central banks are now likely starting an extended pause as they gauge the impact of their unusually rapid series of rate hikes. As we laid out in our H2 Outlook, we favour taking relatively smaller-sized risks within regions, sectors and quality segments, while maintaining balanced allocations across equities, bonds, cash, alternatives and gold.

Fig. 1 US economic data has been surprisingly resilient relative to expectations in recent quarters

US, Euro area, China economic surprise indices

Upgrading US equities

Within our core allocation to global equities, we raise US equities to Overweight, funded by an Underweight in both Euro area and UK equities. This reflects what we see as continued resilience of US economic and earnings growth relative to the worsening outlook in Europe.

While US equities do face risks from valuations and weak leading indicators, we believe there is room for recent outperformance to extend as the start of an economic and earnings recession is delayed by the still-robust US consumer and AI-driven gains. In contrast, Euro area faces a more difficult growth outlook and increased inflationary pressure, which restricts policy flexibility.

Our Overweight on DM Investment Grade (IG) government bonds, of which US bonds are a significant part, remains unchanged. While the precise timing of yield peaks may be debated, historical episodes suggest that bond yields tend to plateau not long after a peak in Fed policy rates. The current absolute level of yield also offers a sizeable buffer against a further near-term rise. As an example, the yield on a US Treasury benchmark index would have to rise by over 0.75% before price losses start to outweigh the 12-month yield.

Sharpening our view on Asia

The second change this quarter is that we reduce Asia ex-Japan equities and Asia USD bonds to core (neutral) holdings.

In China, which remains a key component of Asian equity and bond benchmarks, a significant policy stimulus measure has thus far not been forthcoming. This may not be imminent without a strong catalyst, which does not appear to be in place at this time.

Within a core allocation to Asia ex-Japan equities, we continue to believe regional diversification remains key, to markets including India, which face a more contrasting growth/valuations outlook compared with China. Within Asia more broadly, our Overweight on Japanese equities, due to its cyclical nature, improving buybacks and corporate governance, and still-inexpensive valuations, is unchanged.

Fig. 2 Asian IG bonds have outperformed HY YTD, but limited value is left. HY remains under pressure

Asia USD bonds, IG and HY credit spreads

Within Asia USD bonds, IG bonds have outperformed High Yield (HY) bonds, in line with our expectations. However, IG bond spreads now appear to offer less value, while we do not believe the risk/reward has improved for HY bonds. Therefore, we reduce our allocation to Asia USD bonds to core (neutral) within global bonds.

Adding to EM bonds

Within bonds, we upgrade EM local currency bonds to Overweight. Besides the increasingly attractive yield, we believe that EM central banks, on average, have more room to respond to slowing global growth, which is positive for bond prices. Our view of a weaker USD over 12 months is another supportive factor. The asset class yield and room for price gains are likely to help offset the risk of a short-term overshoot in the USD.

We also close our Underweight on EM USD bonds, bringing our view up to a core (neutral) level. Here, we see a more balanced set of risks. The yield remains attractive and the asset class is sensitive to a fall in US government bond yields. However, EM credit quality remains under pressure amid still-high USD borrowing costs, including more difficult-than-usual refinancing conditions.

Balancing risk/reward in currency markets

Our expectations that US bond yields will ultimately move lower (towards 3.25-3.5% on the US 10-year government bond) on a 12-month horizon remain a key driver of our modestly bearish USD view. We continue to expect the JPY to ultimately be a key beneficiary of this. However, its current status as a low-yielding source of liquidity means any appreciation may not be immediately forthcoming.

On a shorter three-month horizon, a persistent bearish positioning on the USD remains one key challenge to a potential turn lower in the USD. However, we believe a pausing Fed and the fact that the USD is already at the top of its 2023 range tilt the risks towards a possible depreciation.

Yields are likely to remain elevated for longer and still see a good runway for income strategies over the next 6 to 12 months

Fig. 3 Yields on the MAI portfolio still largely supported by fixed income assets

Yields, duration and allocations of bonds, equity and hybrid assets within our MAI portfolio

Stellar double-digit returns from covered calls, Europe dividends and leveraged loans

The MAI allocation faced challenges in Q3, although it managed to eke out a 0.6% absolute return. There were broad-based gains in dividend equities, with Asia dividend equity being the strongest contributor. Credit assets such as DM HY and Leveraged Loans also added to the performance given still-strong corporate earnings and support for the latter from higher rates. Hybrid assets, such as covered calls, also performed strongly in 2023; they were the best-performing asset class within MAI, generating 8.0% return YTD. The key performance detractor was Asia USD bonds.

We expect yields to remain higher for longer, which is favourable for MAI. Our conviction and also our base case is that we are now at peak rates, both from the Fed and the ECB. Policymakers are likely to take stock of what their actions mean for economic growth and review their impact on combating high inflation. In the event of weakening US economic growth, we do expect the Fed to cut interest rates. As such, we see the yield on MAI strategies remaining high relative to history, until central banks are convinced to begin cutting rates in 2024.

Upping equities while dialling back on DM credit and Asia USD

Within our MAI allocation, we are now tilting back to a more balanced allocation between fixed income and equities. We have lowered our 12-month US recession probability to 55% and have also pushed back the likely start to Q2 24. While this view still reflects an elevated risk of recession, we believe recent resilience in economic data supports an uplift to our equities allocation, which is mainly funded from DM HY, leveraged loans and Asia USD bonds.

Fig. 5 Relative performance of Asia dividend equities has been the most outstanding

Relative performance of relevant indices since 21 September 2022

Our uplift in equity allocations added mainly to our regional dividend equities. The broader market sentiment has been relatively uncertain, but equity markets have held up on still-resilient economic data, especially in the US. The performance of global high dividend equities has picked up alongside global equities, led mainly by Europe dividend equities (7.5%) and Asia dividend equities (10.0%), while the US was the only region with a slight negative return (-0.6%) YTD.

Cutting our overall bond exposure, mainly through reductions in DM HY and leveraged loans allocations

We reduce our allocations to DM HY and leveraged loans, taking a more balanced approach between DM HY/LL and US dividend equities. Yields on DM HY continue to look attractive. As such, we continue to retain a sizeable c. 20% allocation to HY/LL, although this has been reduced from its previous allocation of c.25%. However, asset class default rates are beginning to rise due to higher funding costs and tighter bank lending conditions. We believe that these will worsen issuers’ fundamentals and could lead to a deterioration in credit quality. Thus, we have trimmed back on our allocation to HY/LL. While the negative ratings momentum has been more concerning for leveraged loans where the pace of downgrades has been the fastest during the post-Global Financial Crisis period (excluding the COVID-19 period), we retain a largely neutral stance between the two asset classes.

We have also reduced our allocation to Asia USD bonds. The performance of Asia USD bonds has been largely flat for the year, with the Chinese property sector being the key drag. While there have been supportive measures for the sector, such as PBoC rate cuts and credit-easing measures, there are lingering concerns if this recovery can be sustained. Capital markets have also been expecting a much larger-scale fiscal stimulus from the Chinese government to combat the deflationary pressures and achieve their growth target; however, such measures have not yet been forthcoming.

Lastly, we have added to Emerging Market (EM) bonds, especially EM local currency bonds:

1.     EM central banks have likely reached the later stages of the interest rate cycle by this time, with some having cut rates already. This should bode well for returns.

2.     Our expectation for a weaker USD over the next 12 months should act as a tailwind given FX has historically been a key driver for EM local currency bonds.

With the macroeconomic outlook remaining uncertain, a diversified income allocation offers a prudent way to maintain equity exposure. Additionally, the likelihood that major central banks are at, or close to, the peak in the rate hiking cycle means there is an attractive opportunity available to lock in high long-term yields.

How can investors address Chinese market exposure?

China’s equity investors have been facing significant challenges of late. The MSCI China index has fallen by 54% from its peak in February 2021 and has been in a bear market since May the same year. While a drawdown of this magnitude is not unusual for the volatile Chinese equity market, which saw a peak to trough decline of 74% during the Global Financial Crisis, the current selloff has weighed on investor sentiment amid a vigorous debate on China’s long-term trend growth expectations and the optimal policy response.

In this report, we offer a perspective on the evolution of Chinese economic growth, highlight potential positives, mitigating factors against the recent gloom and share our recommended course of action for financial market investors.

Three distinct phases in China’s economic growth:

1. Agricultural reforms (late 1970s – 2000): In the late 1970s, China initiated agricultural reforms and dismantled direct controls, resulting in a remarkable tripling of food production during 1980-2000.
2. Manufacturing export boom (1990s): In the 1990s, China experienced a manufacturing export boom, leading to employment growth, increased incomes and rapid industrialisation.
3. Property and construction boom (2000s): By the mid-2000s, property sector reforms, coupled with the surge in savings from the years of export-driven growth, fuelled an explosion of investments into property and construction and powered China’s double-digit growth for a third decade.

By the early 2010s, however, the two growth engines of the Chinese economy – the exports and property sectors – began to slow. The global share of industrial imports from China remained stagnant at c.25% since 2015 as rising wages drove low-end manufacturing to other economies. Subsequently, housing sector activity also started to slow amid market saturation concerns and efforts by authorities to curb excessive debt and speculation, resulting in defaults by major property developers that further undermined confidence. Concerns about a balance sheet recession emerged in 2023, a scenario where households and businesses focus on reducing debt rather than spending or investing, leading to slower growth.

Fig. 6 The twin growth engines of China’s economy have slowed

Contribution to real GDP from property & construction and export sectors

Fig. 7 China’s consumer and business confidence is low

China’s NBS Consumer Confidence Index and Cheung Kong Graduate School Business Condition Index

The end to rapid debt-fuelled growth

Between 2009 and 2016, China experienced a rapid growth in debt. Overall financial debt levels rose by more than 100 percentage points of GDP over the period amid an accommodative regulatory environment and policy-led stimulus lending. Innovative lending practices, including structured credit products and off-balance sheet credit, proliferated. While this was successful in addressing the growth challenges of the time, bad loans increased and credit quality deteriorated. 

By 2016, after almost seven years of rising debt levels, policymakers shifted focus towards deleveraging and reducing systematic risks. While total debt-to-GDP remained high, it stopped rising precipitously by 2017. More recently, authorities also clamped down on property sector debt. The emphasis on deleveraging ended rapid debt-fuelled growth and likely explains the current policy reluctance to introduce any form of “bazooka” stimulus, which would arguably risk reversing deleveraging gains.

Confidence, a key headwind

As demonstrated by the confidence survey data, consumer and business confidence remains low. Several factors likely contributed to this, including stress in the property sector, prior disruptions to the services sector from COVID-19 policies and regulatory crackdowns on individual sectors. Falling home prices have likely had a negative wealth effect, which in turn can result in households saving more and spending less.

Externally, growing US-China tensions have become another headwind to business and investor confidence. The US ‘Pivot to Asia’ and President Trump’s election and introduction of tariffs by 2018 kickstarted a series of tit-for-tat measures from both sides, particularly in the technology sector. For financial market investors, this resulted in a higher-than-usual level of uncertainty.

Differentiating between slow growth and a crisis

Despite these challenges, an imminent ‘crisis’ is unlikely. Deleveraging efforts since 2016 have improved bank balance sheets, reducing off-balance sheet credit from 20% of total domestic credit to only 6% today. Crucially, Chinese commercial banks, with liquidity support from the PBoC, are expected to continue pursuing loan forbearance and provide liquidity to the credit market. These factors, together with a largely closed capital account, help mitigate the risk of current challenges escalating into a ‘crisis’.

Similarly, the risks of the property and construction sector stress spilling over into a broader credit crisis is also low. Chinese homeowners have significant equity in their homes, as down payment requirements have been high for many years now. A decline in home prices is, therefore, unlikely to result in significant defaults on mortgages. This suggests default risks could be contained within the corporate bond asset class, with the PBoC limiting contagion risks.

Transitioning to a new growth model

Amid the gloom in certain sectors such as property, it is equally important not to lose sight of sectors that fit into the Chinese economy’s transition to a new growth model. China has enormous potential to move up the value-added chain and has achieved considerable progress in the manufacturing of electric vehicles, solar panels, passenger aircrafts and semiconductors. Therefore, it is not inconceivable that China transitions to a high-end manufacturing boom, not unlike the period of rapid export growth in the early 2000s. China’s consumers are also a source of untapped potential. Consumption penetration rates are low and a rise in the consumer’s share in the economy can power the next phase of economic growth.

Investment implications

In our view, the following approach can help investors navigate this mix of challenges and opportunities:

• We are of the view that Chinese assets face challenges from slowing growth, but not from a risk of an imminent financial crisis. Further policy support is likely to be forthcoming, though catalysts for a large ‘bazooka’-style measures are likely not in place.
• One key step to balance the risk/reward trade-off is to ensure allocations to Chinese assets are in line with one’s risk appetite. For example, a moderately aggressive risk profile has a 10% allocation to Asia ex-Japan equities and a 4% allocation to Asia USD bonds. These would be consistent with our current core holding (Neutral) view on China and Asia ex-Japan equities and Asia USD bonds. See page 14 for more.
• We believe it is also optimal to ensure Asian allocations are well diversified. In equities, for example, Japan remains a conviction Overweight, while other Asia ex-Japan markets such as India can offer a very different structural outlook.
• Finally, our sector picks can offer a more focused approach. Opportunities for growth exist in specific sectors, but the risk/reward on broad Chinese equities appear limited in absence of a strong catalyst.

Fig. 8 Chinese equities are inexpensive but not extremely cheap either

Average of 10y percentiles of various valuation metrices*

US leading indicators are still pointing to heightened risk of a recession over the next 6-12 months. We expect Developed Market central banks to hold rates at current levels for the rest of the year and start cutting rates next year as growth slows sharply

Fig. 9 Major central banks likely done with rate hikes; focus shifts to supporting growth

US 12m recession probability, leading indicator; money market expectation of key policy rates

Top macro questions

Will the US avoid a recession? Consensus estimates have shifted from expecting a recession as early as H1 this year to a more optimistic scenario, with no recession expected at least until early 2025, with the lowest point seen in Q1 24 (0.1% q/q annualised growth). This shift is driven by: i) sustained boom in consumption, aided by a robust job market and excess savings accumulated during the pandemic; ii) prolonged impact from record fiscal stimulus during the pandemic; and iii) increased private investment in manufacturing and residential housing. Consequently, we lower our 12-month US recession probability to 55% (slightly below the New York Fed’s 60% probability) and postpone the likely start of a recession to Q2 24.

These recession probabilities are still high by historical standards. i) Consumption is likely to fade after a summertime boom as household excess savings get depleted by early 2024, forcing consumers to rebuild savings. Upcoming student debt repayments are likely to put further pressure on household finances; ii)  the impact of prior fiscal stimulus is likely to wane, with the possibility of additional stimulus constrained by a divided Congress (there is risk of another government shutdown during budget session talks in October); iii) furthermore, the impact of Fed rate hikes over the past 1.5 years are affecting vulnerable parts of the economy, contributing to an uptick in corporate bankruptcies.

These risks explain why our indicators continue to flag heightened risk of a US recession. The Leading Index of 10 key economic indicators (LEI) and the US government bond yield curve have historically been the most reliable predictors of a coming recession. The LEI has reported a y/y decline for the past 16 months, a trend that has historically preceded recessions. Additionally, the US government bond yield curve has remained inverted since July last year (shorter-tenure bond yields have remained above longer-tenure bond yields, signalling monetary conditions are tight enough to cause a sharp downturn in the coming years). At its extreme in March and July this year, the US 10-year bond yield was almost 111bps lower than the 2-year yield, the biggest inversion since 1981. Historically, a US recession has started 9-22 months (median: 16 months) after the 2-year yield rose above

the 10-year yield (this cycle: July 2022), 2-16 months after the curve became most inverted (this cycle: March and July 2023), and 2-6 months after the curve sustainably turned positive again (yet to happen, although in 1982, the curve turned positive almost a year after the recession had started). Based on this history, there is a high probability of a recession starting anytime between Q4 2023 and Q2 2024.

Is the Euro area already in a recession? The Euro area economy has stagnated since H2 last year, with Germany, the region’s largest, contracting y/y since Q1 this year. The latest business confidence indicators (PMIs) suggest service sector activity has started contracting since August, alongside the already depressed manufacturing sector. The ECB’s record policy tightening (450bps rate rise since July 2022) has led to tighter lending standards and a sharp deceleration in borrowing, while China’s economic slowdown hurts the region’s exporters. The region is gradually adjusting to last year’s energy shock after the halt of supplies of the relatively inexpensive Russian gas. Although gas prices have fallen sharply from last year’s highs as Russian pipeline gas is replaced by a surge in liquefied natural gas imports, core inflation remains elevated due to elevated wage pressures amid a tight job market. Elevated inflation is likely to keep the ECB on hold for the rest of the year before a recession leads to rate cuts next year.

Is China’s recovering? China’s economy is showing some signs of stabilising after a sharp downturn in Q2. The latest economic activity data from August show a nascent upturn in domestic consumption. However, the property sector remains the biggest drag, while exports continue to contract amid a slump in global trade. Recent measures seem to have encouraged first time home buyers in Tier 1 cities, although the recovery has yet to broaden. With monetary easing progressively having less effect, investors are looking for more forceful fiscal stimulus, especially targeting cash-strapped local governments. The annual Central Economic Work Conference in December is likely to set the agenda for 2024. We expect measures to boost youth employment via support for advanced technology and green infrastructure.

Fig. 10 The Euro area is leading an economic downturn

US, Euro area, China and Japan Composite PMIs

Fig. 11 Inflation has peaked in the US and Euro area

Core inflation in the US, Euro area, UK, Japan and China

DM IG government bonds offer an attractive risk-adjusted yield; EM LCY bonds to benefit from slower growth, lower inflation and rate cutting prospects

Fig. 12 DM government bonds offer an attractive risk-reward profile; EM LCY government bonds to benefit from lower yields (higher prices) and FX gains

Current yield for bond asset classes and their 10y range; EM LCY government bond price returns, interest returns and EM FX returns since 2013 to-date

Why have you upgraded EM LCY government bonds to Overweight?

EM local currency (LCY) government bonds have delivered a return of roughly 5.7% YTD, largely driven by the yield paid and price gain (falling yield). We believe the asset class can continue to outperform global bonds in the next 6-12 months due to:

1. EM benefits from DM growth resilience. Higher interest rates in DMs should theoretically decrease the relative attractiveness of EM rates. However, we believe a resilient growth backdrop in the US, extended longevity of the current economic cycle, lower but still-supportive commodity prices and prospects of more fiscal stimulus in China could create risk appetite for EM assets.
2. Interest rate cut prospects. We believe easing global inflation has put EM central banks in a better position to reverse monetary tightness when needed. Weaker growth prospects in 2024 and deteriorating global trade and financial conditions can catalyse such a move.
3. EM FX should benefit from a weaker USD. The strong USD YTD has supressed EM FX performance. Falling US bond yields should result in a weaker USD. This, in turn, should translate to EM FX strength and add to EM LCY bond returns.

Fig. 13 Money markets are pricing significant rate cuts in EM countries, especially relative to DM

Implied policy rate differences one year from now

Why are you Overweight DM IG government bonds?

Resilient US growth has prompted a ‘higher-for-longer’ environment for bond yields. This, together with still-strong upward momentum in yields, means we expect the US 10-year government bond yield to stay above 4% in the next three months.

The debate on the precise yield peak notwithstanding, we retain our broader view that the fastest rate hiking cycle in DM is close to an end. Recession risk ahead should drive government bond yields lower. We expect the US 10-year government bond yield to move lower to 3.25-3.50% in the next 12 months.

Why have you downgraded Asia USD bonds and upgraded EM USD government bonds, both to Neutral?

About 50% of the Asia USD bonds asset class comprises Chinese bonds. This may end up being a limiting factor on asset class outperformance from here given a catalyst for significant stimulus remains lacking and the property sector outlook remains challenging. While Chinese authorities have launched a series of stimulus measures to revive the economy, especially the real estate sector, much of this is likely already in the price. Hence, we reduce Asia bonds to a core (Neutral) holding. Within Asia, we continue to prefer IG bonds over HY bonds due to their stronger fundamentals.

We upgrade EM USD bonds to Neutral from Underweight. We believe outlook for EM bonds has improved as a resilient US economy offers support to riskier assets. However, their fuller valuation holds us back from being more optimistic.

Why are you Neutral DM IG corporate bonds and Underweight DM HY corporate bonds?

We believe the prospect of lower rates should support the performance of DM IG bonds due to their relatively high interest rate sensitivity. However, tightener monetary policies and the US small bank crisis in March have already worsened the outlook for corporates, with interest expense burdens a key risk to profit margins. As such, we remain Neutral on this asset class.

For DM HY bonds, we believe its recent strong performance amid stronger economic growth backdrop has reduced its relative attractiveness even further, compared with our preferred bond asset classes. We retain our view that refinancing pressure for HY issuers continues to pile up as financial conditions continue to tighten. We also view the current yield premium as insufficient to compensate for recession (and hence default) risk and a falling recovery rate from recent restructuring events.

Fig. 14 DM corporate yield premium appears tight vs levels seen during previous recession

DM IG and HY corporate yield premium; NBER-defined US recession

US companies continue to defy expectations and deliver solid earnings growth. Meanwhile, the Tokyo Stock Exchange’s initiative to improve corporate governance has led to more transparency and share buybacks from Japanese companies

Fig. 15 US companies’ earnings growth continues to dominate global earnings growth, while Japan is riding on improving corporate governance

US vs global earnings growth (LHS); Japan share buybacks

Upgrading US equities to Overweight

We upgrade US equities to Overweight. US companies beat expectations in the last earnings season, and their earnings growth is expected to outperform others.  AI and technology-related industries are likely to fuel earnings expansion.

Meanwhile, US economic data has been resilient. Inflation is likely to have peaked and could continue to moderate. On the flip side, the region’s valuation remains relatively expensive, the rally is lacking in breadth and the Fed may not pivot as fast as investors expect it to. Our expectation of recession remains a risk, but our view that is likely delayed, especially relative to already-weak European growth, creates room for outperformance.

Fig. 16 US companies show solid fundamentals, while US inflation has been falling

US CPI and MSCI US net margin

Overweight Japan equities

Japan equities remain our most preferred region. The Tokyo Stock Exchange has been encouraging companies to improve their corporate governance. For example, companies with a price-to-book (P/B) ratio below 1 face more stringent disclosure requirements than companies with a higher P/B ratio. This has led to companies improving transparency and their interactions with investors.

Despite the recent rally, valuations vs global equities remain below the long-term average. A potentially strengthening JPY could hinder Japan’s economic recovery and dampen corporate earnings, but an unhedged FX exposure mitigates some of this risk. A potential relaxation of the BoJ’s yield curve control (YCC) policy may lead to heightened market volatility.

Downgrading Asia ex-Japan equities to Neutral

We downgrade Asia ex-Japan equities to Neutral (ie, a core holding), mainly due to China’s lacklustre economic performance, which spills over to the region.

China is flirting with deflation, while other key figures such as PPI and consumption remain weak. The wealth effect trickling down from the pressure on asset prices, such as properties, is likely to dampen sentiment in the near term. The government has been delivering “piece-meal” stimulus to the economy, but more stimulus may be required to have a more sustainable recovery.

We remain Neutral on China within the region. On the positive front, the region’s valuation remains cheap at 20% discount to global equities, which is below the long-term average. We are Neutral China onshore versus offshore, while caveat that potential escalation in geopolitical tensions may dampen the China offshore market’s sentiment.

We expect India equities to perform in line within Asia ex-Japan. They are projected to enjoy stellar EPS in 2023 – north of 20%. However, they are trading at an expensive valuation vs Asia ex-Japan equities, at north of 60% premium on a 12-month forward P/E basis.

Fig. 17 Business conditions remain lacklustre in China

Overall business condition index in China vs MSCI China y/y performance

Downgrading Euro area equities to Underweight

We downgrade Euro area equities to Underweight. The region is currently trading at a significant valuation discount, and positioning is relatively light.

However, monetary conditions remain tight, while there is heightened recessionary risk. Earnings growth has been lacklustre compared with the US.

Underweight UK equities

We remain Underweight UK equities. Valuations remain extremely cheap, but earnings growth outlook is negative and the weakest among all regions.

Inflation remains a key concern and could lead to further tightening by the BoE. Lastly, UK equities are heavy in the Value sectors, which are overshadowed by Growth exposures globally.

Buy consumption-oriented sectors in China

• Our barbell strategy continues in the US and extends to Europe: we prefer secular growth exposure on the one hand, balanced with defensive exposure on the other.
• In China, we would buy consumption-oriented sectors, namely consumer discretionary and communication services.

US

Our view is to buy three sectors – communication services and technology for their secular growth and the defensive healthcare to balance out the risks. Communication services has seen strong earnings momentum with expectations for 2023 growth upgraded, while 2024 growth remains stable. The sector could also benefit from AI applications, and its valuation remains attractive. Technology companies delivered broad surprises in Q2 results and the semiconductor segment is expected to drive a 2024 earnings rebound. AI has sparked significant orders benefitting chip companies, while software companies continue to see defensive recurring revenues. A better macro picture by year end could improve corporate IT spend. Healthcare remains our preferred defensive exposure to balance out the risks as a US recession in 2024 remains our base case. Relative valuation of the sector is reasonable.

Other views: We upgrade Energy to Neutral as producers’ discipline is supporting the oil price. We are Underweight materials amid risk of a growth slowdown especially in China. We are Underweight real estate as high interest rates weigh on property prices. We downgrade utilities to Underweight amid poor price momentum and rich cashflow valuations.

Fig. 18 US communication services and technology sectors are expected to deliver the strongest earnings growth in 2024, while healthcare offers defensive growth

Consensus 2024 EPS growth by sectors in the US

Europe

We upgrade healthcare to Overweight to provide defensive exposure as we turn more cautious on broader European equities. We are Overweight technology, which is expected to deliver among the top earnings growth in 2023 and 2024. Over 50% of the sector comprises semiconductor companies that are expected to benefit from AI investments and structural growth in semiconductor usage.

Other views: Consumer discretionary and financials are downgraded to Neutral as we turn more cautious on the consumer and Europe’s economy. We are Underweight real estate as high rates weigh on property valuations. We are Underweight materials as it continues to see weak demand.

China

Our view is to buy two sectors – communication services, which is dominated by media and entertainment companies that benefit from greater consumer spending and policy support for internet firms, and consumer discretionary,which would also benefit from policymakers’ priority of boosting domestic consumption. Q2 results in both sectors were strong, continuing the strong momentum from Q1.

Other views: We upgrade real estate to Neutral as policy easing is expected to continue. We are Underweight utilities where price momentum has been poor and there is tariff uncertainty. We downgrade healthcare to Underweight amid poor price momentum and corruption issues.

Fig. 19 Our sector views by region

2024 US growth expectations have been revised higher, while those for other countries have been pushed lower. More resilient growth means that the Fed may cut rates at a slower pace than previously expected, limiting USD downside.

Fig. 20 US growth resilience to limit USD downside

FX performance and revision in 2024 growth forecasts; table of forecasts

Growth expectations impact FX performance

We lower our 3- and 12-month EUR/USD forecast to 1.09 and 1.12, respectively.  Rising signs of a growth slowdown due to a combination of higher interest rates and lower Chinese growth have weighed on the EUR. Over the next three months, the correction in the USD and the market’s reassessment of the ECB are likely to push the EUR higher. Over the longer term, strong current account balance, rebound in China and delayed rate cuts from the ECB, which should lead to more favourable interest rate differentials, argue for EUR/USD gains, though a slower pace of Fed rate cuts could limit the gains.

Fig. 22 Fed is expected to cut rates faster than other central banks, which should lead to most currencies appreciating vs the USD

Market-implied policy rate changes till Sep 2024

We expect GBP/USD to be rangebound in the near term, before rising over 12 months. The UK’s growth slowdown and declining house prices are likely to keep markets guessing about the peak BoE rate in the near term. However, the uncomfortably high inflation should eventually push the BoE to hike rates further, which would mean that the GBP could offer the highest interest rate among G-7 currencies.

We revise our 3- and 12-month USD/JPY forecast higher to 145 and 135, respectively. Despite the BoJ now allowing 10-year JGB yields to rise towards 1%, the slow pace of rise in yields has meant that US yields have risen at a faster pace, pushing USD/JPY higher. However, with inflation leading to more domestic discontent, we expect the BoJ to turn more hawkish, which combined with our expectation of lower US yields, should push USD/JPY lower over the next 12 months. However, the trajectory of the decline is likely to be choppy.

The outlook for USD/CHF has turned more balanced and should trade around 0.90. In its latest policy meeting, the SNB paused its rate hiking cycle, as domestic inflation has been below the 2% threshold for the past six months. Our less bullish EUR forecast also reduces pressure on the SNB to be hawkish, given the central bank focusses on the EUR/CHF level to manage imported inflation.

Fig. 23 Recent CHF strength has led to fairly expensive valuation on a nominal basis

CHF Nominal and Real Effective Exchange Rates

While the RBA and BoC may still hike once more, we believe the RBNZ’s next move would be to eventually cut rates. The AUD, NZD and CAD are likely to trade in a range as markets try to assess the next move from central banks. Nonetheless, elevated oil prices and potentially resilient commodity prices, due to our expectation of a growth rebound in China, are likely to be supportive for the commodity currencies (AUD, NZD and CAD) over the next 12 months.

We expect near-term increase in USD/CNH towards 7.30, even possibly 7.38 on a technical overshoot, as the recent PBoC easing will lead to wider interest rate differentials and as the CNH CFETS basket (a measure of CNY valuation) is still not cheap. Over the next 12 months, we expect USD/CNH to decline towards 7.00-7.08 as the CNH benefits from robust domestic growth and potential investor flows.

We expect USD/INR to decline modestly towards 80-81 over the next 12 months. The INR could benefit from a broad USD weakness, strong domestic growth and declining current account deficit. However, greater risk premium ahead of the 2024 elections and weaker current account due to higher oil prices may cap gains. USD/SGD is likely to decline modestly towards 1.35 over the next 12 months. While we do not see any near-term changes in MAS policy, the benefit of strength in EUR, CNY and MYR should be tempered by the move of SGD NEER towards the centre of the band.

Crude oil demand remains weak, but contraction in supply supports oil prices

Fig. 25 The USD strength limits gold’s upside risk; Oil price growth is well supported by production cuts

LHS chart: Gold vs USD Index (DXY, inverse)
RHS chart: Oil price vs crude oil market deficit y/y

Model predicts higher equity market risks

Our US Equity-Bond Market Risk (EBMR) models the downside risks in US equities and the US 10-year government bonds. It uses 11 economic and market factors to create equity and bond risk barometers. If the value of a barometer falls below 50, it signals higher downside risks and vice versa.

The model remains in Stage 1 this month. Its previous move to Stage 2 (bullish equity phase) in June coincided with a 3.2% rise in S&P 500 at the end of July. The shift to Stage 2, however, was only a blip. Current Stage 1 predicts high downside risk in US equities, and low upside risks to US 10-year government bond yield (bond price falls as its yield rises). Since the model shifted to Stage 1 in July, S&P 500 has fallen by 2.7%, but US 10-year government bond yield rose by 36 bps against the model’s expectation.

Fig. 26 EBMR bearish on equity market risks

US equity and bond market risk barometers

The bond barometer has been predicting low US government bond market risks this year. However, the hawkish stance by the Fed has pushed US 10-year government bond yield 46bps higher this year, and this is against what the bond barometer is indicating. Many of the factors behind the bond barometer, however, have also started to fall in magnitude. For example, the contraction in US manufacturing PMI, low broad commodity prices and flattish US capacity utilisation are currently supportive of bonds as they favour defensive assets. These factors are showing signs of bottoming.

The equity barometer has improved slightly this month, but it remains below 50. Momentum in US housing starts becomes a supportive factor once again, but we have cautioned not to read too much into its signals until a clear trend is established as it is a more volatile indicator. Other supportive signals remain largely unchanged and include faltering core inflation and positive medium-to-longer-term momentum in S&P 500. The latter has deteriorated but they remain positive over the time horizons we set (6 and 12 months). High interest rates remain a key drag on the barometer.

Our model’s projections now tilt towards Stage 1 for October and stay mixed for November to January. The downside risks to equities remain sizeable over these periods, with probabilities of Stage 1 ranging between 20% and 39%.

Implications on global assets

Data since 1999 suggest gold and global bonds are the most preferred in Stage 1. The model’s preference for the assets is based on its long-term relationship with the market cycle, which favours defensive assets in Stage 1.

Where is diversity falling or rising this month?

It is another uneventful month since we flagged for reversal opportunities in equities in July. Price trends in broad equities remain weak but not lop-sided in a way that indicates stretched market positioning. We see similar situations in bonds and currencies. The latter has a narrower market diversity compared with last month due to the recent USD rally, but they remain well above the threshold of our diversity indicator.

Most equity markets we tracked have traded flat so far in Q3. Japan and UK equities were the only exceptions as they generated sizeable returns of 5.7% and 3.5%, respectively, since June. Their market diversity is also far healthier than the levels we typically look out for reversal risks. Meanwhile, price action in the US IT sector remains weak. This weakness is not considered extreme, and it will require a longer and deeper sell-off before our diversity indicator starts to flag for oversold conditions.

Fig. 28 Average market diversity score by asset class

Diversity of bonds has risen steeply

Fig. 29 Percentage of assets with diversity score <1.25

No assets showing reversal risks

Diversity for bond markets remains high in general. The lowest diversity is spotted in DM sovereign bonds at 1.44. They had the poorest performance since June (-2.8%) due to their negative sensitivity to bond yields. We recommend keeping an eye out for DM sovereign bonds given its diversity is declining steeply towards the 1.25 threshold. On the other end of the spectrum, EM USD bonds have the highest diversity at 2.18 due to its lack of clear direction.

In currencies, broad USD strength has resulted in narrower diversity across the board. The CNH, JPY, EUR and AUD have all depreciated against the USD by 2.2%, 2.9%, 3.8% and 4.2% respectively. We recommend keeping an eye out for AUD/USD, especially for a potential reversal should further weakness causes its diversity to worsen from current 1.36 to below 1.25. A hawkish Fed for the remaining FOMC meetings this year could also open up similar opportunities in other currencies when their market diversity falls below 1.25.

Fig. 30 Diversity across key assets