Licenced by SFC Type 1, 4 & 9 & MAS Capital Market Services
26 July 2022
“Recession risk and our thoughts”
As we enter the US earnings season this week, we are closely monitoring companies including Apple, Google, Lam Research and Visa for signals on where the overall market is headed.
To help us navigate the uncertainties in the market, we conducted a bull-bear scenario analysis on the S&P 500 by using forward P/E calculations to forecast year-end index levels.
Exhibit 1: S&P 500 year-end 2022 price based on EPS and P/E scenarios – as of June 9, 2022
In a bull case, the FED will orchestrate a soft landing by bringing inflation under control while avoiding a recession. We expect the SPX Index to further rise 5 to 10% above current levels and treasury yields remain moderate at current levels.
In a bear case, the FED’s action may cause stagflation and in turn, a recession – slow economic growth, relatively high unemployment, accompanied by rising prices and defaults. Consequently, we may see another 20% downside from current SPX Index levels and an exit on treasuries holding cash, pushing yields up to 2008 levels at 4%.
Exhibit 2: S&P 500 Index (Source: Bloomberg)
Exhibit 3: US Treasury 10-year yield curve rate (Source: Bloomberg)
For each scenario, we have listed several driving forces as follows.
Firstly, the US household debt serving to income ratio is at its lowest which suggests that households are buffered by pandemic savings. In other words, households can weather higher inflationary costs by either dipping into their savings or expanding their borrowings. Consumer spending accounts for more than two-thirds of US economic activity and has been rising consecutively for 5 months. This might have been one of the reasons why CPI remains elevated but may show signs of slowing down on the back of continued rate hikes.
Exhibit 4: Household debt servicing ratio (Source: Bloomberg)
Secondly, there are currently 11.2 million job openings and 6 million unemployed people – 1.8 jobs for every unemployed person. This suggests that the labour market recovery has much more room to go with alternatives to choose from (exhibit 5). Hiring momentum remains tight and has shifted to the service sector. Additionally, the current average wage growth is below the pace of inflation and wages in lower-income industries are experiencing robust growth rates. Labour wages in this quintile are important as they are more sensitive to rate hikes on their mortgage and loans (exhibit 6).
Exhibit 5: US job openings by industries total (Source: Bloomberg)
Exhibit 6: Average hourly earnings by industry earnings (Source: Bloomberg)
Thirdly, the inventory to sales ratio for businesses such as automobiles their parts are lingering at a historical low due to the lockdowns in China and other factors. This in turn drives inventory building among companies which is not a recipe for recession as per historical events (exhibit 7). Corporate profit margins remain high by historical standards but may mean that recession worries can change HH behaviour which in turn limits companies’ pricing power (exhibit 8). The SPX Index is not trading at an overvaluation at above 1 or 2 standard deviations, unlike other market drawdowns. We are seeing an unusual divergence between the market and both actual and forecasted earnings, which therefore suggests that market participants may be overestimating profit margin cuts due to recessionary concerns (exhibit 9).
Exhibit 7: Inventories to sale ratio (Source: Bloomberg)
Exhibit 8: Z-score of corporate profit margins (Source: Bloomberg)
Exhibit 9: S&P 500 Index P/E and Estimates P/E (Source: Bloomberg)
Firstly, sentiment drives capital flows which in turn dictates market prices. Benjamin Graham famously quoted that “In the short run, the market is like a voting machine–tallying up which firms are popular and unpopular. But in the long run, the market is like a weighing machine–assessing the substance of a company.” The latest fund manager sentiment survey suggests that fund managers are less willing to take risks – similar to that during the 2008 crisis.
Exhibit 10: Net % taking higher than normal risk levels (Source: BofA Global Research)
Exhibit 11: Recession consensus
(Source: BofA Global Research)
Secondly, oil demand has been picking up worldwide. Elevated oil prices will reduce disposable income resulting in lower spending. This may cause negative GDP growth while inflation remains elevated. Central banks will consequently react by further increasing rates. Higher oil prices do not cause recessions per se but are a major factor given their role in global consumption. Oil is also showing signs of weakness as Russia reopens their gas pipelines. Commodities have thus a significantly higher risk-to-reward ratio now.
Exhibit 12: Brent crude futures with recession markers (Source: Bloomberg)
Thirdly, there are many models available to forecast a recession – one of those being the 2-10 Year Yield Curve. However, it has not been a useful indicator due to its false signals in the current market. Another notable model would be the Bloomberg Recession Model. The model entails factors including housing permits, nominal GDP, and financing gap. The probability of a recession in the next 12 months has been raised from 0 to 38%. Moreover, the probability of a recession in the next 24 months floats between 90 to 100%. The primary reason for the rise in probability is the recent plunge in consumer and business sentiment, coupled with the rapid increase in 10-year Treasury yields. The main risks, however, would be the further slowing of nominal GDP growth, weakening of corporate profit margin and the fed fund rate increasing at a dangerous pace. More insights will be unfolded in the coming earnings season.
Exhibit 13: Bloomberg’s recession model (Source: Bloomberg)
Regardless of a bull or bear scenario, there are trade strategies which may benefit your portfolio.
Firstly, we are beginning to see a lot of cash management solutions with 100% capital return or minimum redemption products. Nevertheless, we think that a straddle structure might also be worth considering.
Secondly, there are still some discounted bounds near maturity for the super conservative clients; and the usual ST bond income funds mentioned previously for ST yield play.
Thirdly, there are some funds worth considering for every client portfolio. The Health Science Fund is positioned for the long term regardless of the scenario and the Infrastructure Fund is a short-term defensive play.
Fourth, private credit has been a shielded space during this situation on an MTM basis. The key to choosing PC Funds would be its size with strong backing, and low possibility of default. Therefore, the usual BCRED Fund is a good consideration. Furthermore, many banks can custodise it.
And lastly fifth, to benefit from a bear scenario, we can hedge heavy exposure to US Tech that may require insurance. Put warrants with KO rebates have a small upfront to fund the trade if it’s KO’ed. However, it is possible to lose the whole premium amount.
Our concern of risk of a re-tightening of measures in China has partially materialize although the extent of such measures is fortunately, considered bearable for now. However, the focus in the Equities market has shifted mostly to increasing expectations that the Fed may have over-tightened too fast and in turn, questions how far the Fed can continue to further rate hikes. Accordingly, investors are beginning to rotate into riskier parts of the Equities spectrum, in particular, Growth stocks. In the nearer term, inflation data and expectations will continue to drive the direction of the Equities market. Bear in mind inflation data is a lagging indicator and typically lags approx. 6 – 9 months. With the Fed pulling all stops to curb inflation, we will not be surprised the Fed may overtightened in the coming quarter or two and potentially has to slow down or reverse course with regards to rate hikes in the worst case.
Amid and despite what we believe as the two most pressing macro-overhang on Global Equities investors currently face (i.e., the renewed risks of lockdowns in China and runaway inflationary risks in the US and globally), in recent days global investors are gradually calling a bottom to inflation and pricing in a potential slowdown and end to how much the Fed can hike rates further. Growth stocks have become beneficiaries as investors gradually enter risk on mode. As reiterated in our previous investment meetings, we continue to favour HK/China Equities and are seeing rotation into US Growth stocks, in particular the technology sector.
Major near-term themes to focus: (i) sector rotation into Growth from Value, (ii) focus on market leaders are sectors that were highly in demand and favoured by global investors. In general, we recommend investors to:
a. Overall, we recommend investors to increase their exposure in Growth stocks, in particular US stocks (value to growth split: 50:50) against a backdrop of pricing in a near top to inflationary pressures in the coming quarter and potential positive impact to consumer spending and the global economy at large from the on-going relaxation of containment measures globally;
b. Despite the recent rally in certain sectors, we maintain mid-longer-term overweight in Banks (Singapore banks) on longer term rate hike cycle theme; Chinese Telcos (defensive with dividend), Chinese Autos (in particular EV related themes) and Chinese Healthcare. These sectors are fundamentally attractive over the longer term and may consider accumulating on major pullbacks; Unless inflation shows signs of abating in the US, i.e., take cue from US July inflation data, we remain Neutral on US equities overall. We believe investors should gradually allocate more exposure to US technology in the near-term as investors sector rotate into Growth stocks
Overall, continue to employ more tactical short-term trades in order to capture opportunities arising out of ongoing market volatility; put on partial hedges as well as hold a sufficient level of cash in the portfolio (no less than 10%) to remain defensive and to stay nimble amid continued market volatility.
This material is provided for informational purposes only. It is not a recommendation or solicitation of any investment or investment strategy. There is no guarantee that any investment or strategy will achieve its objectives. Unless otherwise stated, all information contained in this document is from Raffles Assets Management (HK) Ltd. and/or Raffles Family Office Pte Ltd (Singapore) and is as of the stated date on page 1 (top left corner). The views expressed regarding market and economic trends are those of the authors and are subject to change at any time based on market and other conditions and there can be no assurances that countries, markets, or sectors will perform as expected. By acceptance of these materials, you agree that you shall use the information solely to evaluate your investment in this Raffles Assets Management (HK) Ltd and/or Raffles Family Office Pte Ltd (Singapore) sponsored investment opportunity and you shall keep the information confidential.
William Chow – Deputy Group CEO
Mr. Chow brings over two decades of asset management experience and currently oversees Raffles Family Office’s (RFO’s) Advanced Wealth Solutions division while also serving on its Board of Management and Investment Committee.
He joined RFO from China Life Franklin Asset Management (CLFAM), where as Deputy CEO from 2018 to 2021 he oversaw $35 billion in client investments. Mr. Chow also chaired the firm’s Risk Management Committee and was a key member of its Board of Management, Investment Committee and Alternative Investment Committee.
Prior to CLFAM, Mr Chow spent 7 years at Value Partners Group, the first hedge fund to be listed on the Hong Kong Stock Exchange, where he was a Group Managing Director.
He started his career at UBS as an equities trader and went on to take up portfolio management roles at BlackRock and State Street Global Advisors from 2000 to 2010.
Mr. Chow holds a Master’s degree in Science in Operational Research from the London School of Economics and Political Science, and a Bachelor’s degree in Engineering (Hons) in Civil Engineering from University College London in the UK.
Derek Loh – Head of Equities
Mr. Derek Loh is the Head of Equities at Raffles Family Office. Derek has numerous years of work experience from top asset management firms and Banks – 13 Years on the Buy-side across 3 Major Cities in Hong Kong, Singapore and Tokyo. Derek demonstrates in-depth industrial knowledge and analysis, covering mostly listed equities.
Ex-Portfolio Manager for ACA Capital Group, managing a multi-billion dollar global fund for a world-renowned sovereign wealth fund and reputable institutional investors. Previous notable Investors serviced include Norges Bank (Norwegian Central Bank), Bill & Melinda Gates Foundation and Mubadala. Derek holds an Executive MBA from Kellogg School Of Management and HKUST. He is also a CPA.
Sky Kwah – Director, Investment Advisory
Sky Kwah has over a decade of work experience in the investment industry with his last stint at DBS Private Bank. He has achieved and receive multiple awards over the years being among the top investment advisors within the bank. He often deploys a top-down investment approach, well versed in multiple markets and offering bespoke advice in multiple assets and derivatives.
Prior to his role, he worked at Phillip Capital as an Equities Team leader handling two teams offering advisory, spearheading portfolio reviews and developing trading/investment ideas.
He has been interviewed on Channel News Asia, 938Live radio, The Straits Times and LianheZaobao as a market commentator and was a regular speaker at investment forums and tertiary institutions.