Overview

• 1Q 2023 presented some good news on the global economy. The U.S. consumer and labor markets remain in good shape, while the euro area managed to avoid fuel shortages and a recession. In addition, China’s economic reopening has been swift.

• However, there are some early signs that higher rates are pressuring the economy and the banking sector. While developed market central banks are still worried about inflation, we should be approaching the end of the rate hiking cycle.

• China’s initial recovery momentum is encouraging, and the rebound in consumption has benefited the services sector in Asia. The market requires additional boosts from further corporate investments and a recovery of the property sector. Loose fiscal and monetary policies may help, but corporate and investor confidence may take time to recover.

U.S. economy: On the path to weaker growth

• The U.S. economy is expected to decelerate further into the year. Corporate spending and construction activities have already slowed due to higher borrowing costs. Corporate investments may be pressured by weaker earnings. Recent banking sector stress could further reduce banks’ appetite to lend.

• Household spending and the labor market are still bright spots of the U.S. economy. However, declining savings and rising credit card debt could limit consumption growth later in the year. While large corporations are reducing their workforces to help manage their profit margins, small and medium enterprises in the services sector are still hiring and filling vacancies.

• Historically, slower residential investments and corporate spending have preceded economic recessions in the U.S. As it stands, history could repeat itself this year. The good news is both household and corporate balance sheets are in good shape, which should keep a downturn—if it happens—brief and shallow.

Federal Reserve: Staying on a hawkish path

• Despite the threat of an economic recession, the Federal Reserve’s (Fed’s) top priority remains taming inflation. Prices of food, energy and core goods have come into better balance and should contribute less to inflationary pressure. Shelter cost has also started to peak, but it may take some time before its full impact is clearly reflected in price indices.

• Recent troubles in the banking sector may persuade the Fed to take a more balanced view on policy tightening, especially as commercial banks are starting to be more cautious in lending.

• Following the March Federal Open Market Committee (FOMC) meeting, we believe the Fed is closer to the end of the hiking cycle. Despite problems with the banking sector, market expectation for aggressive rate cuts before the end of 2023 may be premature.

China: More growth engines needed

• With its COVID-19 policy largely in the rearview mirror, domestic consumption in China should gradually recover to pre-pandemic levels. Corporate investments will likely be the next focus for growth, aided in part by supportive monetary policy. This could be an important growth lever for the economy as China is unlikely to find meaningful support in export demand in view of a slowing global economy. China’s exports are expected to remain weak in 2023.

• The relaxation of certain policies as they pertain to the real estate sector should help to stabilize developers’ finances. However, buyers’ sentiment may remain challenged amid growing expectations of paltry long-term returns from real estate.

• Beyond the re-opening story, we believe the next phase of China’s industrialization will be key in delivering sustainable growth. This includes developments in renewable energy, advanced manufacturing, import substitution and technology services.

Asset allocation: Building resilience in the face of weaker growth

• We continue to prefer fixed income over equities with the rising risk of a recession later in the year. This could pressure profit margins and earnings, limiting equity performance in the near term.

• In contrast, the domestic consumption recovery and ongoing loose monetary and fiscal policies in China should be more supportive of related sectors. Broad support of the ongoing economic recovery has been reinforced in the National People’s Congress meetings. This could have positive spillovers on the services sector in Asia, while a decisive rebound in exports may take time.

• At current valuations, high yield corporate bonds are vulnerable to credit spread widening as weaker growth could drive up the prospects of default. As a result, we prefer high-quality fixed income, including government bonds, investment-grade corporate credits and mortgage-backed securities.

Asia equities: Prioritizing domestic demand recovery

• The economic reopening theme in China has progressed quite meaningfully. The next leg of the market rally will require evidence of a more sustained economic momentum. This may primarily arise from corporate investments, as a rebound of the real estate sector seems unlikely for now. Longer-term growth themes, such as renewable energy, advanced manufacturing and import substitution, could provide a solid foundation for a sustained rally.

• Earnings expectations have been significantly downgraded for tech hardware-dependent markets, such as Taiwan and South Korea. Inventory adjustment should also be nearing an end. Recovery in these markets would depend on two factors. The first would be the recovery of the U.S. and European economies. The second would be the emergence of a new service or concept that could potentially become a fresh structural growth catalyst for semiconductors and other electronic components. The potential breakthrough of artificial intelligence chatbots and related services may be one such candidate.

Fixed income: Focus on high-quality bonds and lengthen duration

• Current credit spreads for U.S. corporate bonds are consistent with steady economic growth, reflected across many recent indicators. However, the growth pinching effects of higher for longer interest rates suggest a meaningful risk of spread widening and falling bond prices. In the event of a recession, U.S. government bond yields could decline and this may partially offset spread widening. We expect high-quality corporate bonds to exhibit some degree of resilience in this scenario.

• With banking sector stress and potential weakening of economic data, we believe the upside risk to bond yields is becoming limited and this duration can be offset by income. Hence, we should see greater demand by investors to lengthen duration as higher rates weaken growth outlook.

• The weakening trend of the U.S. dollar could provide a more favorable backdrop for EM fixed income. Many EM central banks are also approaching the tail end of their interest rate hiking cycles, and this will likely reduce overall duration risk. The rebound of the Chinese economy could also shore up the fundamentals for Chinese and other Asian companies.

U.S. dollar: Long-term bearish

• We expect several factors should weaken the greenback in the medium to longer term.

• First, the European Central Bank could continue to raise interest rates well beyond the end of the Fed’s tightening cycle. The Bank of Japan may also choose to revise its Yield Curve Control policy. These could put pressure on the U.S. dollar against the euro and Japanese yen.

• Second, the U.S. may not outperform other developed and emerging markets on account of the growth dampening effects of tighter monetary policy. China’s economic reopening could add to Asia’s growth outperformance relative to the U.S., allowing for some recovery in Asian currencies.

• Third, U.S. dollar depreciation from its overvalued position typically benefits EM and Asia fixed income and equities.

Investment Implications

• We maintain our preference for fixed income over equities, given the risk of higher U.S. rates in the near term and a rising possibility of a recession later in the year. Higher rates could prompt some valuation de-rating for growth stocks, while weaker growth could undermine the earnings outlook further.

• High-quality U.S. companies, and companies primarily serving domestic demand in China and Asia could exhibit relative resilience to a potential economic downturn in the U.S. In terms of Chinese equities, in addition to the reopening theme, sector beneficiaries of China’s industrial policies could draw interest from investors.

• Likewise, weaker growth could lead to wider credit spreads. As a result, government bonds and high-quality corporate credits should exhibit greater resilience. Cooling inflation and weaker jobs data are crucial signals to increase duration. A potentially softer U.S. dollar later in the year may also benefit emerging market (EM) fixed income.