“The ‘higher for longer’ narrative now likely the base-case scenario”
In the upcoming FOMC meeting on 2ndNov 2023, it is widely expected that the FED will continue to hold current rates at 5.25-5.50%. The markets have mostly priced in that the FED rates have peaked at current levels, with a ~30% chance of one last hike. However, in the scenario that the FED continues with an additional hike to 6%, the markets has not priced that in, and we would likely experience even higher volatility.
Figure 1: CME Fedwatch Futures Table
Comparing the rates futures and analysts’ forecasts, we are now seemingly inline vs 1 quarter ago when many analysts were “over-optimistic” regarding peak rates and the anticipation of earlier of rate cuts. We now have some consensus that the rate cuts will only begin in 2Q24.
Figure 2: Analysts Forecast (FED Funds Rate upper bound)
However, looking towards the mid-term, we also see in figure 3 that the rate cut cycle is not expected to be as aggressive as first thought. Rates are expected to remain well above 3% in the next 24months, above the FED’s long-term target of 2.5%. The “higher for longer” narrative has now been accepted as the base-case scenario.
Figure 3: Fed Funds Rate and ECB Depo Rate
Another key data point that we have been observing is the 10-2yr yield curve spread. As we have discussed before, the curve is still inverted (short term yield is still above long-term yield) but it seems to on the trend towards normalising. We were at -100bps in June 2023 vs -15bps currently. This could signal a positive development for the longer-term US economy as short-term interest rates fall below longer-term rates, a reflection of expectations that the US economy will revert to a normal economic cycle and continue to expand steadily.
Figure 4: 10yr-2yr Yield Curve Spread
To add on further, we have also seen a fundamental change in the yield curve over the past 6months. The Yield curve has been flattening vs 1 month and 6 months ago – longer duration yields are rising faster than shorter duration, also known as “bear steepening”. Overall, we are seeing a “flattish” yield curve across maturities. This implies that investors’ expectations have shifted to indicate that they are indifferent holding a shorter-term bond vs a longer-term bond – a signal that the markets are anticipating the end of rate hikes but is also not expecting rate cuts any time soon, further adding to the “higher for longer” narrative.
Figure 5: Yield curve over different durations
Now, let uslook at how asset classes historically react to yield curve normalization. Equities tend to fare relatively poorly on the initial onset. This may seem counterintuitive as falling rates is typical a bullish signal for equities, however the real determining factor is a sharp drop in corporate earnings – if a recession indeed occurs. Consumer demand weakens, firms lose pricing power and revenue shrinks further. Fixed income on the other hand tends to do relatively well in this environment, and in the current “bear steepening” stage, investors will tend to benefit from holding shorter-dated vs longer dated bonds.
Figure 6: Historical asset class performance after yield curve nomalisation
In figure 7, reported SPX earnings-per-share has been muted over the quarters with divergence amongst certain sectors growth and decline thus making sector picks even more crucial during this time.
Figure 7: S&P 500 earnings-per-share
Despite the US still seeing ~70% of companies reporting earnings above estimates, this is below both 5-yr average of 77% and 10-yr average of 74%. Further, Q4 guidance has also been lacklustre, with ~55% of companies issuing a negative EPS guidance vs expectation – which further add on to the market retracement. However, such a moderation of forward guidance can be helpful in re-managing investors/analysts expectations. Setting a lower benchmark can lead to investors feeling more comfortable taking moderate risks which can be beneficial towards capital allocation and investment decisions.
Figure 8: Earnings scorecard 3Q23 across sectors
Fixed Income Macro
Interest rates are in a further elevated range as 10-year and 30-year US Treasury yields increased 29-33 bp month to date. Remarks from Fed Chair Powell interpreted the recent increase in longer-term yields as mostly due to term premium rather than to changed expectations for the path of short-term interest rates. As such it represents a pure tightening of financial conditions not motivated by an improved economic outlook. Because of this “at the margin” the Fed may need to do less to tighten financial conditions. On whether the Fed is done with the tightening cycle, he commented that “Additional evidence of persistently above-trend growth, or that tightness in the labour market is no longer easing, could put further progress on inflation at risk and could warrant further tightening of monetary policy.” It is expected that the Fed funds rate will be unchanged at the November meeting, while keeping the option alive for hiking at subsequent meetings.
Rising rates were a major drag for fixed income 3Q23 total returns and the environment is likely to remain challenging with outflows being felt particularly in emerging markets. EM hard currency bond fund outflows deepened from $5.8 billion in September to $6.3 billion month to date, taking outflows to $30.5 billion year to date. The Bloomberg Asia USD Credit spread widened 6 bp over the past two weeks which gives rise to the question whether a larger risk premium is required. In a higher-for-longer interest rate environment, outperformance is more likely for EM countries that maintain a stable macro backdrop and are less reliant on international funding markets, and for corporates that implement tender/buyback/calls, supported by bank loans or local bond issuance, underlining their ability to refinance amidst more challenging external markets. That said, uncertainty over future resilience is a risk of “higher for longer” rates. Material repricing of such risk may push spreads 50-100 bp wider.
In China, industrial production posted a fourth consecutive monthly increase and a rebound in export sector activity suggests that a significant external impulse is underway. The notable surprise in September was the pickup in retail sales, which added to a large August gain. Easing of financial conditions looks to be gaining more traction as total social financing (TSF) increased by a stronger-than-expected RMB 4.1 trillion in September. The government is raising the 2023 budget deficit to 3.8% of GDP from the 3% limit set in March including RMB 1 trillion (equivalent to 0.8% of GDP) of additional sovereign debt issuance, which will be allocated to infrastructure spending. From the credit market perspective that positive macro data may lead to discontinuation of policy support, the decision to lift the 2023 budget deficit comes as a positive development. Should the Biden-Xi meeting occur at the APEC CEO Summit over 14th-16th November, it can also be incrementally supportive for China credit.
Fixed Income Strategies
While recent remarks from Fed policymakers suggested higher long-term yields may reduce the need for additional hikes, they have made no such suggestion for the ongoing quantitative tightening process. QT will be contributing to higher yields for longer since the Fed is continuing to reduce its bond portfolio at a $720 billion annual pace amid a supply increase of longer-dated Treasury debt that the market will have to absorb to fund the US fiscal deficit. The Treasury projects that further increases in sizes will likely be necessary in future quarters. Marginal demand from large Treasury buyers such as Japanese investors will be less as they are rotating to JGBs. In the meantime, 3Q inflation prints coming in a bit softer than expected should be supportive for the short end of the curve. On balance, this favours lower yields over the near term in the 2- to 5-year sector than longer tenors, as the growing supply/demand imbalance points to higher term premium over the medium term.
US Budget Deficits Force Treasury To Issue More Debt
Source: Bloomberg Finance L.P.
Within the Asia HY sector, the China property HY default rate for 2023 YTD continues rising on the back of Country Garden’s default. Although ~75% of China property HY bonds comprise issuers that have already defaulted or conducted distressed exchanges, the broader impact on Asia HY is likely limited. First, the market value of remaining non-defaulted China property HY issuers is at distressed valuations, indicating that pricing already reflects significant stress within the segment. Second, the China property HY segment constitutes just ~5% of Asia HY market value. Going forward, the impact from China property HY to the overall Asia credit market is likely to be marginal. Asia ex-property HY valuations have improved – front-end India HY yields are currently at 8-9% range while Macau gaming operators offer similar yields. Reflecting the backdrop of risks, we are inclined to position in BB-rated issuers from these segments that are likely to be more stable, and in issues with short to medium duration.
China nationwide property sales showed sequential improvement with September sales rebounding 42% month-on-month. However, the year-on-year number dropped 14% with average selling price falling 4% month-on-month and 4% year-on-year. On the back of the home purchase and resales restrictions easing and reductions in downpayment ratios and mortgage rate so far, the easing impact appears falling behind expectations. New home sales remain weak with median primary Gross Floor Area sold falling 9% month-on-month and 36% year-on-year in October so far, following moribund Golden Week sales. Secondary market property prices fell 0.5% month-on-month. As recovery in the physical market remains challenging, we are inclined to maintain positions in SOE investment grade developers vs underweight HY developers.
China Home Price Declines Deepen Despite Stimulus Measures
Source: Bloomberg Finance L.P.
As previously reiterated, we recommend to gradually accumulate on any material market dips at more reasonable valuations in selected technology counters as well as in defensive and laggard sectors such as consumer staples and healthcare in the US, which offers more attractive risk/reward should the US economy enters into a soft landing in 2024 and in view of the strong YTD run-up in the US technology sector in general. In addition, the energy and defensive sectors could also serve as attractive hedging options if the conflict in the Middle East escalates.
For HK/China, we are and still remain cautious of the inadequacies of the policies and smaller scale stimulus implemented thus far to revive the economy. Nevertheless, we note that the real estate sector is showing initial signs of stabilization as the conscientious efforts of the Chinese government lift hopes that they stand ready to provide the necessary relief/support should the economy continue to deteriorate. We believe the Chinese government will likely continue to monitor the outcomes of these implemented measures for some time before any major step-up in stimulus, if any, is considered. Hence, we are of the opinion that any further significant stimulus, if materialize, will likely come later rather than sooner. Against these backdrop, we recommend investors to consider gradually adding some selected Equities exposure in HK/China in a staggered approach on significant market pullbacks while patiently awaiting 1) signs of recovery in the Chinese economy as a result of the current slew of smaller scale stimulus implemented or 2) further major stimulus, in particular those targeted at the real estate sector, that could revive slowing growth and market sentiment. Furthermore, we recommend a significant portion of these selected HK/China Equities exposure to be gained through Index ETFs rather than individual securities in order to mitigate market and P&L volatility and in the worst case, if further major stimulus fails to materialize.
Our preferred sectors are Technology, EV-related and Travel-related industries. We are also inclined towards infrastructure-related names in view of a potential accommodative policy stance. These sectors are trading at attractive valuations, 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 with decent valuation upside. While we continue to monitor key data points, in particular those that could lift the real economy, market sentiment and hence a rebound in Equities, we reiterate that portfolios should stay nimble and diversified. Overall Equities exposure should remain moderate to low as year-end looms with increasing geo-political tensions and as most of the concerns that plagued global Equities throughout the year still linger.