23 September 2022
Weekly Market View
The Fed leads yields higher, stocks lower
The US Federal Reserve took another decisive step this week to burnish its inflation-fighting credentials as it signalled an aggressive pace of rate hikes in the coming months. In doing so, we believe it has raised the odds of a US recession to 75% in the next 12 months.
As we have flagged in recent months, the near-term implications are likely significant. By the end of the year, we expect the 10-year US government bond yield to rise towards 4%, the 2-year yield to rise above 4.5% and the USD to strengthen further, resulting in a further drawdown in equities.
We prefer a three-pronged approach (the ‘3 Ds’) to mitigate the impact for investors: 1. De-risking of allocations; 2. Diversifying into less volatile USD-denominated Investment Grade corporate bonds; and 3. Increasing exposure to other income assets, including consistently high dividend paying equities.
Given the hawkish Fed stance, is it the right time to invest in income generating assets?
What are the implications of the latest Fed decision for equity investors?
What is the outlook for Emerging Market currencies, given USD strength?
Charts of the week: Where to seek refuge as the Fed keeps hiking
Asia USD and Developed Market bonds have historically provided attractive returns during similar regimes
Fed and money market estimates of the Fed policy rate*
12m asset returns in a falling-growth, rising-inflation regime**
Source: Bloomberg, Standard Chartered; *dots represent Fed member forecasts; **global economic regimes identified by BCA Research (2005-21)
The Fed leads yields higher, stocks lower
The US Federal Reserve took another decisive step this week to burnish its inflation-fighting credentials as it signalled an aggressive pace of rate hikes in the coming months. In doing so, we believe it has raised the odds of a US recession to 75% in the next 12 months. As we have flagged in recent months, the near-term implications are likely significant. By the year end, we expect the 10-year US government bond yield to rise towards 4%, the 2-year yield to rise above 4.5% and the USD to strengthen further, resulting in a further drawdown in equities.
The Fed, besides delivering its third consecutive 75bps rate hike, projected the benchmark rate to rise 125bps in the remaining two meetings of this year and another 25bps next year to a peak of 4.75%. Almost a third of the Fed’s 19 policymakers are more hawkish, projecting the so-called ‘terminal’ rate at 5% next year. That is steeper than the 4.5% money markets were pricing for the peak rate going into this week’s Fed meeting. The main message from the Fed was that it is willing to sacrifice growth to soften the US job market and accept an unemployment rate above its 4% long-term target so that it can sustainably bring down inflation towards its 2% goal.
As higher rates eventually lower growth and inflation, the central bank expects to cut rates in 2024, a year later than previous market expectations. At his press conference, Fed Chair Powell gave three conditions for pausing or slowing the pace of rate hikes: below-trend growth, softer labour markets and clear evidence that inflation is moving back to 2%. Based on the latest projections, while growth is expected to remain below trend until 2024 – driving up the unemployment rate to 4.4% by next year – inflation is not expected to return to the 2% target until 2025. This week’s lower-than-expected jobless claims is only likely to embolden the Fed. This portends higher-for-longer rates, in our view, which is likely to tighten global financial conditions, especially with the ECB and the BoE also hiking rates (the BoE delivered a 50bps hike this week to a 14-year high of 2.25%, even as it warned that the UK economy likely contracted again in the July-September quarter).
We prefer a three-pronged approach (the ‘3 Ds’) to mitigate the impact for investors: 1. De-risking of allocations by reducing exposure to equities and government bonds, which are among the most vulnerable to rising rates; 2. Diversifying into less volatile and high quality USD-denominated Investment Grade corporate bonds in Asia and the Developed Markets (DM), which now carry the added attraction of paying the highest yields in a decade; and 3. Increasing exposure to other income assets, including a basket of consistently high dividend paying equities, which tend to outperform in high inflation regimes.
Within equities, the de-risking could start with reducing exposure to Euro area equities, especially with the rising risk of another Russian incursion into Ukraine. There is also the risk of Russia cutting off oil supplies after having already sharply cut gas supplies to Europe. Meanwhile, the US S&P500 index, which entered a bear market this week for the second time this year, is likely to test June’s intra-day low of 3,637. Momentum indicators show US stocks are oversold in the near-term, but a break below June’s lows could lead to a test of 3250-3540. Stocks in Asia ex-Japan and UK offer much better value, in our view, given their 28% and 45% price-to-earnings discount vs. US equities. Asia ex-Japan stocks have the added advantage of a steady stream of policy stimulus from Mainland China. Next week’s China business confidence indicators (PMIs) will be closely watched for signs of further economic recovery.
Asia and DM USD-denominated corporate bonds are our top picks in bonds given their relatively low volatility and yields above 5%, which are likely to cushion against further rise in government bond yields. These bonds have historically delivered some of the highest returns in an environment of slowing growth and rising inflation (see chart above). They also provide exposure to the rising USD, which we expect to strengthen further in the next 3 months, despite Japan’s FX intervention to revive the JPY. History suggests unilateral FX interventions provide only a short-term respite, but underlying fundamentals (rate differentials) prevail over the medium term.
— Rajat Bhattacharya
The weekly macro balance sheet
Our weekly net assessment: On balance, we see the past week’s data and policy as negative for risk assets in the near term.
(+) factors: Easing China lockdowns, Euro area fiscal support
(-) factors: Hawkish Fed, ECB and BoE; Ukraine crisis
The Fed raised its US inflation, unemployment and rates forecasts and cut its growth estimates
Fed’s macroeconomic forecasts, September vs June
US housing starts rebounded in August, but the trend remains downward amid rising rates
US housing starts
BoE rates are expected to rise just above Fed rates over the next two years, but the ECB and BoJ rates are expected to lag behind
Money market estimates of Fed, ECB, BoE and BoJ policy rates over the next two years
Top client questions
Given the hawkish Fed stance, is it the right time to invest in income generating assets?
By any count, the latest Fed meeting was a hawkish one. Fed guidance not only pointed to faster and higher rates than previously expected, but also highlighted its willingness to sacrifice growth to curb inflation.
Having said that, in our assessment, the level of long-term bond yields suggest markets are being pulled in opposite directions by the risk of a hawkish Fed and downside risks to growth. In this context, we expect the 10-year bond yield to rise towards 4% by the end of the year, before falling back towards the 3.5-3.75% range by the end of Q3 2023. Corporate bond yields across most major regions are trading close to their highest level in over a decade.
Additionally, history shows high dividend equities tend to outperform broader equity markets during periods of high inflation as their high dividend yield and generally lower P/E ratios make them less vulnerable to the impact of rising interest rates.
Together, these factors argue that while timing the peak in yields remains difficult, we believe risk/reward across bond and dividend yield equities are increasingly attractive to start adding exposure as part of income generation strategies.
— Abhilash Narayan, Senior Investment Strategist
Most higher yielding corporate and Emerging Market bonds now offer sufficient yield cushion to offset any decline in prices as a result of up to 1% rise in yields over a 12-month period
Simulated total returns of fixed income assets assuming different shifts in bond yields
What are the implications of the latest Fed rate decision for equity investors?
A continued rise in the Fed policy rate poses a risk to equity markets because higher interest rates lead investors to apply a higher ‘discount’ to future corporate earnings, putting pressure on equity valuations. The rising rates come against the backdrop of faltering technical indicators – the S&P500 index has already broken below the 3,900 support level. Key support now sits at 3,637, which is the year-to-date intraday low reached in June. We believe it may be difficult to break that level in the short term as momentum indicators such as the RSI are already at heavily oversold levels. However, a scenario where the 3,637 level breaks could open the door to the S&P500 testing its next key support zone between 3,250 and 3,540.
This backdrop notwithstanding, we note that high-dividend equities outperform broader equity markets during rising inflation regimes due to their consistent earnings and income generation potential. We retain our sectoral preference for the energy sector globally, which continues to lead in terms of earnings. We also retain our preferred stance on UK equities due to the market’s high exposure to defensive sectors and high dividend yields relative to global equities.
— Michelle Kam, Investment Strategist
The next key support level for the S&P 500 index is at 3,637
S&P 500 Index
Top client questions (cont’d)
USD/CNH recently rose past 7. How will this affect China equities?
The CNH has weakened against the USD within the context of broad USD strength. Historically, a strong USD has been a headwind to Asia ex-Japan equities, including China equities. This is likely linked to capital flows, where a strong USD has been correlated with a flow of capital out of Emerging Markets and back towards the US. For Hong Kong-listed Mainland China equities trading in HKD (which, in turn, is pegged to the USD), the currency translation impact from a weaker CNH is also a headwind on HKD-denominated share prices. A stronger USD could also raise the cost for companies reliant on imported raw materials and energy.
On the other hand, MSCI China equities have a heavy domestic focus, generating 87% of their revenue domestically. As such, the majority of MSCI China companies are less exposed to currency fluctuations. Instead, government policies and China’s economic growth have a greater bearing on MSCI China equities. The investor base for onshore China equities is also strongly biased towards domestic Chinese investors. With China at a phase where policy is turning more stimulatory (as opposed tighter policies in the US and Europe), we continue to expect China equities to outperform global equities on a 12-month horizon.
— Fook Hien Yap, Senior Investment Strategist
Broad USD strength has historically been a headwind to Asia ex-Japan equities, including China equities
Relative performance of MSCI Asia ex-Japan to MSCI AC World and the US dollar DXY index (inverted axis)
What is the outlook for EM currencies given the USD strength?
The USD surged to a fresh 20-year high after the Fed raised rates by 75bps and projected further hikes at upcoming meetings. Yield differentials continue to favour the USD, which, in turn, has been a key headwind for EM currencies this year. We believe that the USD uptrend has not exhausted itself, suggesting these headwinds could continue for EM currencies in the near term.
USD/CNH broke above the key psychological level of 7.00 last week. While the PBoC is likely to continue efforts to slow currency weakness, by setting stronger daily reference rates and cutting FX reserve requirements, for example, these are unlikely to be sufficient to completely reverse the current downtrend in the CNH. The next key resistance for the USD/CNH sits at 7.20. USD/SGD is also back above 1.42, a level last seen in 2020. The MAS is likely to continue tightening policy at its October meeting amid continued inflationary pressures in Singapore, offering further support to the SGD. Against the backdrop of a stronger USD, we believe USD/SGD is likely to be range-bound near-term, with support at 1.390 and resistance at 1.442.
— Nataniel Tang, Investment Strategist
USD/CNH continues to trend higher towards key resistance at 7.2
USD/CNH with technical levels
Market performance summary*
Our 12-month asset class views at a glance
Economic and market calendar
Next resistance for the US 10-year bond yield is at 3.8%
Technical indicators for key markets as on 22 September
Investor diversity remains reasonably high across assets
Our proprietary market diversity indicators as of 22 September
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