Quarterly Perspectives 4Q 2022

THIS QUARTER’S THEMES

Overview

• Investors have been focused on when central banks may pivot but have been presented with head fakes and side steps. U.S. and European growth is likely to weaken as monetary policy gets tighter and living costs rise. Any prospect of a pivot towards looser monetary policy is likely to be delayed.
  
  
• For China, the hope for economic recovery hinges on its COVID-19 strategy. A more pragmatic approach to managing the pandemic would boost confidence and possibly inject more optimism into the housing market. For the rest of Asia, the export outlook will be challenging after two years of strong growth. The region may sidestep the problem if activity in the service sectors and domestic demand picks up as their economies reopen.
  
  
• The U.S. dollar is likely to stay firm. Oil prices could see sporadic spikes on the back of supply disruptions, whether coming from Russia or other key producers. Recent natural disasters (heat waves, droughts, floods) reiterate the importance of governments to step up investment in renewable energy to diversify energy sources and tackle climate change.

U.S.: Walking the recession tight rope

• Consumer confidence and manufacturing new orders are showing worrying signs as the economy transitions to a lower growth path. Whether the U.S. falls into a recession is still a close call. Even if it does, we believe it would be a mild recession given household and corporate leverage is not excessive.
  
  
• Rising borrowing costs are delaying business investment. Banks are also becoming more cautious in lending, and this could further pressure corporate investment. A cut back in non-residential investment has been a regular feature of U.S. economic recessions.
  
  
• Healthy job growth and limited increase in labour supply are keeping the unemployment rate at a low level. While average hourly earnings are expanding at a decent pace of above 5%, strong inflation means real wage growth is still negative. Hence, rising living costs are preventing a strong labour market translating into buoyant consumer sentiment. A weaker housing market may add to the woes.
  
  
• The good news is that headline inflation should continue to ease in the months ahead on cheaper gasoline, cars and travel services. However, core inflation, especially shelter costs, could stay elevated, and this would be a key reason for the Federal Reserve (Fed) to maintain a hawkish stance.

China: Confidence boost

• The recovery in the Chinese economy was fleeting as stringent pandemic policies and a weak job market held back consumer confidence. Monetary easing has yet to translate into stronger lending growth, with banks reluctant to step up lending and businesses having limited appetite to borrow. More fiscal spending on infrastructure, including renewables, can be expected.
  
  
• Cautious consumers are also hampering the improvement in the residential property market, despite the rollout of stabilisation measures at local levels.
  
  
• The equity rebound in June illustrates what investors could expect if the Chinese economy starts down another path to recovery. The pandemic control policy is key, and many are expecting a more pragmatic shift after the Party Congress in mid-October.

Central banks: Hold the line

• The top priority of the Fed is to contain inflation, even if this means weaker growth for an extended period. We expect the policy rate to reach 4% by the end of 2022 and another one to two 25bps hikes may be in the cards for 2023. The European Central Bank also noted the sacrifices needed to push inflation back to target. Policy rates are unlikely to come down in 2023 unless there are fresh shocks to the economy that threaten financial stability.
  
  
• Most Asian central banks are still on track to raise interest rates but are less aggressive than developed market counterparts.
  
  
• China and Japan are the exceptions in a world of tighter monetary policy. The Bank of Japan still believes domestic demand is on fragile footing and hence its impact on inflation is limited. It is likely to maintain its yield curve control. For China, monetary easing has yet to translate into faster lending growth. The current economic momentum would require monetary policy to stay loose, even though additional rate cuts may not be forthcoming.

Asset allocation: Defense is the best offense

• Given the downside risk to economic growth in the U.S. and Europe, and the determination of central banks to cool inflation, we maintain our focus on managing portfolio volatility and prefer fixed income over equities. This also calls for diversification¹ across asset classes and different regions.
  
  
• The negative correlation between bonds and stocks is yet to be fully restored, but with limited upside to bond yields, we believe the benefits of diversification¹ should return, especially taking into account the relatively low volatility in fixed income, compared with equities.
  
  
• While rising yields in 1H 2022 have already triggered valuation de-ratings across the majority of asset classes, equities could face more pressure on the back of earnings downgrades, especially in the U.S. and Europe.
  
  
• Our emphasis on quality continues. Pricing power and ability to manage downside risk of profit margins will be valuable in weathering a period of weak growth and elevated price rises. Following the risk rally in the summer, valuations in corporate bonds are reflecting a more benign growth outlook and low defaults.

¹Diversification does not guarantee positive returns or eliminate risk of loss.

Equities: The great rotation (again)

• Geographically, the U.S. and Asia (including China) are relatively more attractive, and sector selection is critical. In the U.S., potential earnings downgrades in the months ahead mean investors should focus on defensive and quality companies. The question of whether to start positioning for growth stocks, such as technology and health care, is gaining traction. The likelihood of the peak of interest rates and bottoming out in economic data in the months ahead should provide a more promising backdrop.
  
  
• For Chinese equities, the June rally showed what is possible given attractive valuations, if the economy is on a firmer recovery path. Regulation reform is less of an issue, and we are waiting for the economy to turn around. As discussed previously, pandemic policy is an important pivot to a more constructive outlook.
  
  
• For the rest of Asia, tech-linked export companies have already corrected, reflecting a weaker outlook. For now, economic reopening benefiting domestic demand and services should still be the dominant theme for Asia. This implies leaning towards ASEAN markets.

Fixed income: Unwanted volatility

• The prospect of weaker growth reinforces our preference for investment-grade corporate bonds over high-yield debt in the near term. There is a risk that government bond yields will rise but it is more likely they will fall, increasing the preference for duration. The risk rally in 3Q 2022 means that corporate credit spreads are back to pricing in a low risk of economic recession. We believe the risk for further spread widening in high-yield bonds is meaningful as economic data softens.
  
  
• However, for investors with a longer investment horizon and less sensitivity to bond price volatility, the structural fundamentals of high-yield corporate bonds are in decent shape. The maturity profile for the next 2-3 years is undemanding.
  
  
• Securitised assets fall within the broader bucket of core bonds and are a way to diversify credit risk. The U.S. housing market may slow down, but strong structural demand should keep prices supported. Moreover, there are also interesting opportunities in the non-agency asset-backed space where consumer delinquencies remain low and fundamentals stay resilient.

Alternative assets: Income and diversification

• Investors with access to alternative investment strategies can make use of them to generate income or manage volatility in the more challenging economic outlook.
  
  
• Hedge funds should be able to take advantage of the volatile market environment with their broad range of tools, including long-short strategies and derivatives.
  
  
• Real assets typically have low correlations with economic growth. Some real assets, such as infrastructure, may also generate high income. The revenue of these assets is sometimes inflation-linked, which also helps provide hedging benefits to high-inflation environments.

U.S. dollar and commodities: Stronger USD and energy price spikes

• Despite very rich valuations, a hawkish Fed and market concerns over weaker economic growth could still push the U.S. dollar (USD) higher. This could pressure emerging market (EM) currencies. However, EM currencies’ performance this year has varied significantly, reflecting the importance of differentiation. Currencies with strong current account positions, ample foreign exchange reserves and credible central banks should be more resilient to a stronger USD.
  
  
• The energy market, both oil and natural gas, could see sporadic price spikes in the coming months. Demand in the west could decline on the back of rising energy prices, but the recovery in Asia offers a new source of demand. Meanwhile, supply disruptions, through the Russia-Ukraine conflict or with other major producing countries, could exacerbate shortfalls.

Sustainable investing: Mitigating extreme events

• 2022 has seen some extreme weather events, from heat waves across the northern hemisphere to droughts, floods and wildfires. These illustrate the impacts from climate change and the unexpected economic consequences. For example, droughts impact water transportation in Europe and China. Low water levels mean hydroelectric power stations cannot operate, and there is not sufficient water to cool nuclear power plants, not to mention food security issues.
  
  
• The economic damage from these events is not easily addressed quickly with fiscal or monetary policies. Governments across the world will need to set up long-term plans to diversify their energy sources, building a network of renewable energy sources and reducing greenhouse gas emission.
  
  
• This implies sustainable investment is not just a nice thing to do, but it is a necessary step to mitigate the damage from climate change.

Investment Implications

• Given the more cautious growth outlook, we still expect fixed income to generate comparatively better risk-adjusted returns than equities. For equities, the bulk of the valuation de-rating may be behind us, but 2022-23 earnings downgrades could be the next challenge to market performance, especially for the U.S. and Europe. We are waiting patiently for factors supporting growth stocks to fall into place. This includes the likelihood of the peak of interest rates, and also clearer signs that the economy has reached bottom. Asian markets can benefit from domestic demand recovery, especially for ASEAN. China’s rebound could be meaningful at a time when developed market growth is waning, but depends on the approach to COVID-19.
  
  
• Investor sensitivity towards price volatility in bonds may influence their approach to fixed-income markets. Government bond yields have limited room to rise, which implies a longer duration profile. Current valuation on corporate bonds reflects a relatively benign economic outlook but not a full recession, which could be challenged in the months ahead. In this case, investment-grade bonds are in a better position to mitigate volatility. However, the structural fundamentals of the U.S. high-yield debt market are healthy. An undemanding maturity profile implies default rates may rise, but not significantly, in an economic downturn. The current yield is hard to overlook for investors who are less sensitive to short-term bond price fluctuations.