THIS QUARTER’S THEMES

Overview

• The global economy is set to decelerate as we head into 2024. Europe’s growth momentum is already weakening on the back of higher rates. We believe the U.S. could follow suit in 2024 if the U.S. Federal Reserve (Fed) insists on keeping rates higher for longer. Meanwhile, China’s recovery continues to be held back by the real estate sector.

• With the interest rate cycle having peaked or expected to peak in most economies, the coming months will be a key window of opportunity to lock in high rates via fixed income. Confirmation of the end of the hiking cycle in the U.S. could drive investors to increase duration in both fixed income and equities.

• In fixed income, this implies extending duration via long-dated government bonds and investment-grade corporate debt. Meanwhile, high yield corporate debt could be temporarily undermined by widening credit spreads. For equities, growthier sectors should benefit from falling yields.

• Despite weaker growth momentum, the U.S. is still likely to remain relatively more resilient versus Europe and other developed markets, which could lead to the relative outperformance of U.S. equities. Asian domestic demand is still robust, contributing to earnings growth, especially in Japan, India and ASEAN. A pick-up in the electronic goods cycle could eventually benefit markets such as Taiwan and Korea.

Feeling the pinch from higher rates

• Contrary to expectations, the U.S. economy is approaching the end of 2023 in relatively good health and recession risks are more balanced. Despite early signs of a slowdown, consumer spending and the job market remain largely resilient. This is likely the result of households and corporates locking in cheap borrowing costs before the hiking cycle began in earnest in 2022, helping to buffer the sharp rise in rates.

• The pace of inflation is cooling and should continue to do so, even if it takes another 12-18 months to move closer to the Fed’s 2% target.

• However, if the Fed keeps its policy rates elevated for much of 2024, the buffer against high rates will start to wear thin and could still push the economy into a lower growth trajectory. Hence, an economic recession cannot be ruled out, especially when room for fiscal stimulus is much more constrained with a divided Congress ahead of the 2024 elections.

A Fed that needs to find balance

• A strong labour market and above-target inflation have continued to keep Fed officials hawkish. Even if we are already at the tail end of the hiking cycle, the Fed may still be keen to keep policy rates high in 2024 to fully quash inflation pressures.

• In addition to the policy outlook for the next 12-18 months, the 2023 Jackson Hole central bank symposium also discussed various factors affecting policy making in the long run, such as climate change, supply chain shifts and the Russia-Ukraine conflict. One possible outcome is that the neutral rate—the interest rate that keeps the economy on an even keel—may have risen, justifying a higher rate environment.

• The Fed’s hawkish attitude contrasts with already tight bank lending standards, muted business confidence and softening construction activities. This could lead to an eventual bull steepening of the U.S. Treasury yield curve as market participants contemplate potential growth risks and the prospects for rate cuts. While the Fed might be determined to keep rates higher to quash inflation, it will eventually need to take a more balanced view between controlling price pressures and avoiding a recession.

China: Rebuilding confidence in the economy

• China’s post-pandemic economic recovery has stalled with the real estate market still in the doldrums. Private sector investment remains weak and consumer spending growth in home-related items, such as electric appliances and furniture, constrained by weaker-than-expected home sales. Meanwhile, the contraction in exports reflects broader challenges facing Asian exporters.

• The authorities have introduced various measures to support the economy, including cutting interest rates and relaxing home purchase restrictions for selected cities. However, boosting home sales and construction activities will require policies directed at improving market expectations of property prices. Beijing will need to delicately balance restoring confidence in the property market with maintaining housing affordability.

• The banking sector, especially the larger state-owned banks, has adequate capital and loan loss provisions to buffer against a potential rise in non-performing assets and reduce systemic risk in the financial system. However, financial stress among property developers could linger as home sales take time to recover.

Passing the peak

• The end of the hiking cycle in the U.S. should be constructive for both equities and fixed income. The broader asset allocation decision between equities and fixed income should be dependent on the individual investor’s risk profile. However, the macroeconomic and policy backdrop will likely determine the allocation decisions within asset classes, as opposed to across asset classes.

• For example, the peak in rates typically coincides with a bull steepening of the U.S. Treasury yield curve. This means yields could fall more at the short end of the yield curve than the long end. Lower yields historically benefitted stocks with higher valuations. Typically, this is constructive for growth-style equities and the technology sector.

• Peaking cash rates could potentially persuade investors to take a closer look at deploying cash to tap investment opportunities. Money market funds could be useful on account of their flexibility and liquidity versus a fixed time deposit, in our view.

Diversify global equities

• The U.S. has avoided an earnings recession so far, given the resilience of its economy. However, with interest rates potentially staying higher for longer and economic momentum slowing, the current 2024 earnings per share growth forecast of 12% seems optimistic.

• Nevertheless, with European economic growth slowing to a crawl and China’s drawn out economic reorganisation, U.S. equities could continue to exhibit relative outperformance, especially if there are further breakthroughs in artificial intelligence that could fuel investors’ optimism.

• Outside of the U.S., we believe a more diversified and active approach is important to capture varying degrees of economic growth and as well as valuations at what could be the latter stage of the economic cycle.

• Domestic growth momentum across the region, especially in India, Japan and ASEAN, is supporting corporate earnings.

Retain quality bias in fixed income

• The Fed’s hawkish stance and strong job and inflation data has benefitted the short end of the U.S. Treasury (UST) curve. In coming months, the eventual confirmation of the end of the hiking cycle should see the UST curve decline and steepen, or at least be less inverted. On a total return basis, the long end of the curve could potentially outperform.

• As growth momentum in the U.S. slows, investors’ focus could shift to the possible rise of defaults in the high yield space, leading to a widening of credit spreads and lower bond prices. As a result, high yield corporate bonds could temporarily underperform investment-grade corporate debt.

• While weak domestic home sales will hang over Chinese corporate debt, the economic and corporate fundamentals for other Asian and emerging market corporate bonds appear more constructive. The end of the U.S. hiking cycle should also lead to a weaker U.S. dollar, which could present an additional tailwind for Asian and emerging market fixed income.

Investment Implications

• A peak in policy rates could nudge investors in the direction of longer duration assets, including government bonds and growth stocks.

• In our opinion, locking in yields should be a priority for investors as government bond yields could move lower in 2024 amid the end of the U.S. hiking cycle.

• Among developed market equities, U.S. stocks are likely to continue to lead the way. Outside of the U.S., we believe a more diversified approach is important to capture varying degrees of economic growth as well as valuations at what could be the latter stage of the economic cycle.