“A hawkish June pause with a median projection of two additional hikes in 2023”

Macro

We entered 2023 with several headwinds, including a rapid interest rate hike cycle, escalating US-China trade tensions, and a banking crisis. Despite these challenges, US equities have defied expectations and experienced a significant rally in recent weeks. In this week’s investment roundup, our team explores the factors contributing to this unexpected performance and relevant strategies to navigate the market rally.

Initial predictions in January anticipated a shallow and short-lived US recession to commence in the first quarter of 2023. However, due to stronger-than-expected consumer spending, the first-quarter earnings per share (EPS) for the S&P 500 surpassed expectations ¬– with an upside surprise rate of 7.7% compared to 1% in the previous quarter. Consequently, economists have revised their US GDP forecasts and delayed their recession predictions by one quarter.

Several factors may explain the year-to-date performance of US equities. Firstly, the markets have experienced excess liquidity stemming from prolonged quantitative easing measures and the stimulus provided during the Covid-19 pandemic. Secondly, the short-term positive effects of inflation on growth and employment have motivated consumers and businesses to spend and invest sooner, expecting rising costs in the future. Thirdly, the “TINA effect” (There is no alternative) has influenced investors to favour holding stocks over reverting to cash, even in the face of a challenging macroeconomic environment. Lastly, there are also signs of a “FOMO effect” (Fear of missing out). It remains unclear whether the market never priced in a recession or if it has already factored in a recession earlier and more rapidly.

Both the equal and market-weighted S&P 500 indexes have followed a similar recovery path when accounting for the influence of mega-cap stocks. Currently, there is a market discount of approximately 9% from all-time high levels since October 2021, leading to the question of whether there is further room for upside potential.

Despite a relatively small yield gap of ~1.2% and a lack of clear drivers, US equities have outperformed bonds. This discrepancy raises concerns about the sustainability of the current market rally. Additionally, the return premium for equity risk has diminished significantly, suggesting that short-duration investment-grade corporate bonds might offer a more favourable risk-reward balance compared to equities.

Considering the importance of a US geographical allocation tilt in driving returns, a prudent approach to risk management is recommended in tandem with a long-term strategic asset allocation. Instead of reducing exposure, we favour implementing profit-taking strategies in cyclical sectors that have already outperformed. This approach allows investors to (1) increase cash holdings and/or (2) rebalance into defensive sectors that have lagged.

Profit-taking strategies can include the direct sale of equities, via decumulators (DQ), selling covered call options, or even selling put options. The choice of strategy would depend on the individual’s investment views and goals.

In sum, as the US equity market continues to rally amidst challenging circumstances, investors should exercise caution and consider implementing prudent risk management strategies. Taking profits in overperforming sectors and reallocating to lagging defensive sectors can help balance portfolios. Moreover, assessing the potential advantages of short-duration investment-grade corporate bonds over equities can provide a more balanced risk-reward profile. By navigating the market with a calculated approach, investors can position themselves for long-term success in view of an expected Fed rate cut next year.

Fixed Income Macro

Reflecting a longer period of US economic resilience, the FOMC delivered a hawkish June pause with a median projection of two additional hikes in 2023. The impact on bonds has been muted, which can be attributed to several factors. First, the Fed Chair signalled a step-down in the pace of hiking. At a new quarterly pace, a July hike will raise the hurdle for a September hike. Instead, the November meeting will be the more likely candidate for the second hike that FOMC members currently envision. Second, to the extent May PPI came in below expectations, inflation appears moderating. Third, US consumer short-term inflation expectations fell in June to 3.3%, the lowest since March 2021 and down from 4.2% expectations in May. As a result, markets appear unwilling to price the Fed’s 5.75% terminal rate projection at this point.

Credit spreads broadly have tightened this month on perception that the “Fed is almost done” and this theme appears to remain in place, despite policymakers signalling more interest rate increases may be needed this year. The upward guidance has been accompanied by an upward revision in the Fed’s growth expectations which should be supportive for earnings—at least partly justifying the market’s reaction to the message. Meanwhile, the Bloomberg Asia USD Credit spread at 259 bp currently, near year-to-date tights and below both year-to-date and 12-month averages of 282 bp and 320 bp respectively, screens as expensive in the context of a late-cycle environment.

In China, May activity data show that the property market, the largest sector in the economy, weakened again. Property investment growth declined to -10% year-on-year and property-related products underperformed in industrial production and retail sales data. Consensus estimates for 2023 GDP growth forecasts have been trimmed to 5.5% or lower. That the PBOC reduced the 7-day reverse repo rate to 1.9% from 2% and 1-year medium term lending facility (MLF) rate to 2.65% from 2.75%, the first cuts in 10 months, leads expectations of more monetary easing ahead as part of a stronger push to revive confidence and shore up the waning recovery. Further policy stimulus could be introduced around the July Politburo meeting, depending on activity data this month and next.

Fixed Income Strategy

The FOMC’s hawkish message has led markets to phase out rate cut expectations or a pivot to lower interest rates any time this year. A slower pace of hikes also means fewer cuts priced beyond 2023. On valuation, bond yields are in the upper end of year-to-date ranges. To the extent that reduced bank lending and increased T-bill issuance will replace expected monetary tightening, suggests some value in owning duration currently. In the event core PCE proves stickier than expected, the quarterly pace of hikes should reduce the severity of any bond selloff. Taken together, extend rates duration of bond portfolios.

We maintain up in quality credit positioning. If the Fed is almost done as expected by the market, credit spreads may continue to tighten slightly or move sideways in the immediate term. Assuming a current late-cycle environment, spread widening in an eventual US recession should be significant if history is any guide for USD credit markets overall. Looking back further than the last two outlier recessions driven by black swan events and observing more typical recessions, the expected widening for investment grade credit is 80-100bp, while high yield could easily widen 200-250bp on increased risks to earnings and more defaults. Considering that in such a scenario, high quality credit spread widening is more likely to be offset by lower core government bond yields as monetary easing starts to be priced, this should drive relative outperformance of high-quality credits.

We are inclined to trim China AMC positions. Since Great Wall AMC failed to release its 2022 financial results, it has until end-August to do so, to avoid triggering an event of default on its offshore bonds, which would increase downside risks across the AMC sector. Government support for Great Wall and other national AMCs is strong, evidenced by 2021’s bailout of Huarong by Citic. AMCs play an increasingly important role in dealing with distressed assets amid the worsening credit cycle, especially non-performing loans related to distressed property developers. However, the AMC sector’s spreads are near 12-month tights while historically they have been susceptible to large mark-to-market volatility.

China AMC Spreads Near Range Tights

Source: Bloomberg Finance L.P.

Equities Strategies

We maintain our view that the probability of any rate cut this year is low as key macro data such as a strong labour market and consumption are still holding up. Our previous recommendation to investors on swing trades in blue-chip Technology stocks should have yielded substantial returns and we are now inclined to gradually take profit/trim some of these positions. Although we have preference for some of the large-cap and quality growth stocks, it is important to be selective against a backdrop of extremely overbought AI plays. In addition, we are also inclined to have position in defensive and laggard sectors such as consumer staples and healthcare, which offers more attractive risk/reward should the US economy enters into a soft landing in 2H’23 as widely anticipated.

For HK/China, we continue to remain overweight in beneficiaries of the China reopening theme despite the slower-than-anticipated “reopening” thus far on hopes of potential stimulus from Chinese government in 2H’23 and attractive valuations. We favour Chinese airlines, domestic consumption-related, travel-related and F&B-related sectors. We are also skewed towards infrastructure-related names in view of an accommodative policy stance that might be more industry specific as opposed to a broad blanket stimulus for the entire economy. These sectors are still trading at attractive valuations and deserve our attention be it from a longer-term fundamental perspective or that of a short-term swing trade. We also continue to be advocates of defensive sectors such as Telecoms and Utilities that provide reasonable dividend yields and valuation upside.

Last but not least, we recommend portfolios to remain nimble and defensive through holding higher cash levels or increase hedging.