“US economic soft-landing is achievable but Fed’s job is not yet done”

Macro

Over the past week, the Fed, ECB and BoE delivered hikes as widely expected, with the first 2 central banks making the case for further hikes in the upcoming meetings to normalize inflation. At the same time, macro data remained strong. The global all-industry PMI jumped in January, with constructive news on orders and inventories. In the US, continued strength in employment was evident in January non-farm payrolls increasing 517k, well above consensus forecasts. Growth concerns raised by the US December service-sector surveys were also alleviated as the January PMI rose modestly and the ISM services activity rebounded sharply above 60. Taken together, these developments support optimism that a US economic soft-landing is achievable but also the message that the Fed’s job is not yet done.

The uncertainties surrounding the Adani Group are mostly idiosyncratic in nature, and less likely to have broader contagion or systemic events for the India offshore credit market. Moody’s estimates that the exposure to Adani loans is less than 1% of total loans for most banks. The concentration in operating assets or projects, rather than at the holding company level, further mitigates risks to banks. However, financing pressure on the Adani companies may increase on reduced market access and/or if banks require the companies to start repaying some debt to deleverage. Thus far, large spread widening across Adani Group USD bonds in the past 2 weeks contrasts with limited impact on India credit over the same period.

China delivered a strong increase in January service-sector PMIs, +12.8 pt to 54.4, the highest reading in seven months. This aligns with expected reopening economic activity being led by entertainment, tourism and transportation sectors. One weakness is export performance, as reflected in Caixin PMI export component reading at 48.7 and the recent emphasis from the State Council on supporting trade activity. China USD credit spreads compressing 110 bp YTD to 282 bp, the tightest level in the last 12 months, and 21st percentile in last 10 years, appear to have largely reflected the economic rebound upon reopening. Spreads are unlikely to compress further but are staying at current levels due to lack of issuance in the sector, which can change quickly.

China USD Credit Spread At 12-Month Tights

Source: Bloomberg Finance L.P.

Fixed Income Strategy

Despite recent hawkish hints from Fed officials and data reflecting improvement in the macro-outlook, market participants are currently pricing in circa 100 bp of Fed funds rate cuts between 3Q23 and 3Q24, and 10-year US Treasury yields are 55 bp below their October peak. The magnitude of downward pricing in yields appears at odds with the decline in recession risk. The longer the current regime of lower rates and tighter spreads persists, the more likely risk-reward deteriorates. The opportunity cost of positioning in cash or T-bills yielding over 4% is lower currently.

Maintain position in Macau gaming operators. Despite gross gaming revenue (GGR) of Macau’s first Lunar New Year post reopening being 46% of January 2019’s GGR, this was better than consensus expectations and indicative of pent-up demand from the domestic market. This is likely to lead to faster increase in free cash flow and improvement of credit metrics, although new primary issuance could slow the pace of spread tightening. In the meantime, some issues still offer attractive yield cushion against potential market volatility.

Position in South Korea tech exporters that have lagged onshore credit spread tightening YTD. In Korea, financial conditions are poised to ease as the Bank of Korea appears nearly at the end of its tightening cycle and after the government pledged at least KRW 50 trillion won in support to contain a credit crunch triggered by the onshore default of a Korean property developer, providing some relief to onshore credit markets. South Korea tech exports to mainland China this year may benefit given Korea’s historical sensitivity to mainland China’s business cycle.

Trim positions in India corporates and banks. Currently, spreads of the sector ex-Adani companies’ bonds are almost unchanged YTD. Although broader contagion or systemic risks are unlikely, the current uncertainties are expected to weigh on investor sentiment towards the broader India corporate sector. There are no large debt maturities from the Adani issuing entities coming due in the short term, however a longer-dated risk is that India banks’ exposure could increase if the Adani companies’ access to international capital market declines.

Equities Strategies

As recessionary risk still remains, overweight in defensive positions for US equities, e.g., consumer staples and healthcare. With the current data, we viewed that the global recession may not be a hard one but more of a soft-landing. This should allow carefully selected companies in the US market to remain attractive, given the resilience of the US market during an economic downturn (relative to other global markets) and companies that would still be able to retain profits and margins despite a slump in the economy. Underweight in US consumer discretionary due to significant reductions in spending by both businesses and consumers during the actual recession or even the anticipation of a possible recession.

Overweight Chinese telecommunications companies for dividends and defensive plays. Overweight Chinese airlines, travel-related, entertainment-related as well as consumption sectors which shall continue to benefit from the China re-opening theme. Continue to ride this strong wave in selected sectors and names but also look for opportunity to take profit and invest in other markets (e.g., US) in quality companies with strong fundamentals that can withstand an economic slowdown.

Research

Chinese equities have rallied as China’s reopening gained momentum since the start of this year. Seasonally adjusted China Manufacturing PMI has rebounded faster than expected in January and is expected to normalise in the coming months. The Chinese State Council has also confirmed that Covid-19 infections peaked in late December last year with minimal risks of a second wave. Factory workers are expected to return to work as scheduled. However, we caution that China’s export sector remains weak as global demand tapers due to increased recessionary risks. The US chip export ban on China will also likely add further drag. With that being said, the strength of the recovery in Chinese spending and travel data signals further confidence to investors.

Against the backdrop of favourable macro tailwinds, the Hang Seng Index price-to-earnings ratio has risen relative to S&P500 Index as global fund managers add net exposure to China. We hold the view that a large portion of the Chinese reopening narrative has been priced in. Evidently, Covid-sensitive sectors such as dining, entertainment and consumer staples have recovered.

Nevertheless, we still observe pockets of opportunities in lagging sectors such as airlines and consumer discretionary. The Dragon Tail International Survey finds that Chinese travellers are not planning to travel overseas early this year due to a myriad of concerns including health, the inconvenience of applying for travel documents, busy work schedules and worries over safety and unfriendly destinations to Chinese. Chinese airline equities that predominantly operate along international flight routes remain beaten down relative to HSI but are well-positioned to benefit from an expected recovery in airline passenger traffic in 2H 2023.

The prolonged Zero-Covid lockdown in China has also resulted in excessive household savings and pent-up demand. The Consumer Discretionary Spending Index is still a laggard against the broader market. We believe that pent-up demand will likely drive savings to be spent on consumption goods thus providing a tailwind to the sector.