Finishing the year strong?

As we enter the final stretch of 2021, asset returns have largely met investor expectations set at the start of the year. Global equities delivered respectable results to Asian investors as the global economy continues to recover. Fixed income had a more challenging time as risk-free rates started to pick up, especially as developed market central banks have begun to move away from their emergency monetary measures. Although several problems, such as high energy prices and supply chain disruptions, are still lurking in the background, we still prefer a pro-risk tilt in asset allocation to allow investors to benefit from the rebound momentum.

Taking away the emergency measures

A growing number of developed market (DM) central banks are reining back their ultra-loose monetary policies. The Reserve Bank of New Zealand raised its policy rate by 25bps to 0.5% in early October. The Bank of Canada ended its quantitative easing program and indicated that it could be looking to raise policy rates in 2Q 2022. The Reserve Bank of Australia has stepped away from defending its bond yield target and allowed short-term bond yields to spike. The Bank of England, which targets headline inflation, has also warned that it will “have to act” to rein in medium-term inflation expectations.

Their reactions are probably due to the fact that inflation is looking more stubborn than initially thought and starting to spill over into areas such as housing. More importantly, economic recovery in developed economies is building on more solid ground as their governments are striking a balance between containing COVID-19 and allowing economic activities to continue. This has led to the short end of the yield curve rising and various DM government bond yield curves flattening. The normalization of monetary policy is expected to keep undermining the total return of fixed income assets.

Europe and Japan are the exceptions here. The Bank of Japan continues to forecast inflation to stay below its 2% target for at least another two years and cut its GDP growth forecast in the latest monetary policy committee meeting. Meanwhile, the European Central Bank (ECB) downplayed the threat of inflation, but investors do not seem convinced and started to price in that the ECB may need to abruptly change direction and start to raise policy rates by mid-2022.

COVID-19 and the supply chain

The developed world’s policy stance toward the COVID-19 outbreak is increasingly shifting toward an endemic. While governments are still monitoring pressure on the health care system when deciding how stringent social distance measures and lockdowns should be, the overall direction is for more economic activities to resume. The overall number of new cases in the U.S. and Europe is also coming down ahead of the winter months and pressure on health care is manageable.

For Asia, the number of new infections is also coming down in most economies. Some countries, such as Thailand, have allowed more international visitors to enter in a bid to revive their tourism sectors. The rest of the region is also reopening their domestic services, which should help to improve earnings outlooks. China is still sticking with its zero-tolerance policy, and this is likely to remain in place at least until the Winter Olympics is completed.

The reopening of ASEAN economies should provide some relief to the global manufacturing supply chain since factories in Vietnam and Indonesia were impacted by the outbreaks. The Christmas holiday peak season coming to an end should also help to reduce some of the log jam at ports. Nonetheless, the rise in energy prices could still impact on growth outlooks for 4Q 2021 and 1Q 2022 for Asian economies. Despite the less dovish stance of developed economy central banks and the upcoming quantitative easing tapering by the Federal Reserve, we think Asian central banks will still be patient with normalizing their monetary policies.

Investment implication

Our overall view on asset allocation remains similar to previous quarters. Although valuations could dampen the absolute return of equities in the next 12 to 18 months, we still think this is more attractive relative to fixed income. Moreover, the latest round of corporate earnings from the U.S. and Europe is still solid, despite uncertainties from rising costs and logistic challenges.

The global economic recovery should continue to evolve, with Asia and emerging markets taking up the next bright spot. Asian companies serving local consumers and businesses should benefit from a more sustained rebound in domestic demand. For China, economic momentum is still relatively weak. Regulatory reform and constraints on the real estate market are likely to remain in place ahead of next year’s 20^th Party Congress. Fiscal and monetary policies should start to turn more supportive, which should help to stabilize growth in 1H 2022. We believe the underperformance of Chinese equities, especially in the offshore market, has already factored in much of this economic weakness and regulatory uncertainty. Although a robust rebound will need the revival of investor confidence, long-term investors could start to look for opportunities to re-engage in the Chinese markets.

For fixed income, managing duration risk is still the key, especially given the normalization of monetary policy in developed economies in the next 12 to 18 months. Corporate high yield bonds and emerging market (EM) fixed income could provide the combination of short duration and high income that should be resilient in a rising yield environment. In EM fixed income, active management is critical given the divergence in central bank policy outside of Asia. In Asia, corporate credit risk, especially for Chinese real estate developers, will also require in-depth research to identify opportunities from price dislocations.

Global economy:

• The U.S. September headline consumer price index (CPI) topped expectations at +5.4% year-over-year (y/y) before seasonal adjustment. Core CPI rose 4.0% y/y, driven mainly by shelter inflation, suggesting that above-trend inflation may linger for longer. Meanwhile, the U.S. September employment report showed just 194,000 nonfarm payrolls were added, well below consensus expectations. This miss was mitigated by a decline in the unemployment rate from 5.2% to 4.8% and a modest increase in the average workweek.
  (GTMA P. 26, 27)
• China’s real GDP grew 4.9% y/y against the consensus of 5.5%, as COVID-19 lockdowns, power outages and real estate slowdowns all weighed on economic momentum. Retail sales grew by 4.4% y/y, below the 8% pre-pandemic average, which shows how regional Delta outbreaks and supply bottlenecks have disrupted the recovery. Meanwhile, investment activities have been subdued, as we estimate that fixed asset investments declined 2.5% y/y, with a major drag coming from the real estate sector.
  (GTMA P. 6, 7)
• Tackling with tepid inflation expectations, the Bank of Japan kept its interest rate targets unchanged and also cut its real GDP growth outlook and consumer inflation forecasts for 2021. The European Central Bank also kept rates unchanged as it believes higher inflation will fade next year.
  (GTMA P. 19)

Equities:

• After a difficult September, global equities mostly bounced back in October, driven mostly by positive earnings reporting. U.S. equities performed particularly well, as the S&P 500 and NASDAQ rose 6.9% and 7.3%, respectively in the month. Europe and UK equities were also up 5% and 2.1%, respectively. As U.S. Treasury (UST) yields continue to rise and stagflation fears ease, value and cyclical sectors outperformed growth.
  (GTMA P. 31)
• In China, better-than-expected quarterly earnings were offset by downward revisions in economic forecasts and diminishing monetary easing hopes. The CSI300 and Hang Seng Index rose moderately on the month, gaining 1.86% and 3.42%, respectively. Within emerging markets, Brazil notably fell 9.1% on the month after a 14.6% fall in September, driven by sluggish growth, higher rates and concerns over the country’s fiscal outlook.

Fixed income:

• Concerns about persistently high inflation have pushed up market expectations for global policy rates beyond the guidance provided by the respective central banks, causing the yield curve to flatten. In the UK, the combination of firm overall growth, a strong labor market and intense supply and price issues is putting pressure on the Bank of England to raise rates as soon as November.
  (GTMA P. 55)
• U.S. investment grade corporate debt was largely unchanged at +0.2% in October, as the positives from strong corporate earnings were offset by higher-than-expected supply. Continued concerns over Chinese real estate developers as well as the downward revisions in China’s and Japan’s economic data have impacted EM and Asia fixed income, with the high yield segment falling 5.2% in October.
  (GTMA P. 51, 53, 54)

Other assets:

• The U.S. dollar index fell slightly by 0.1% as the rise in 10-year UST yields slowed down in October. The British pound appreciated against the greenback for most of October with a more hawkish central bank, ending the month +1.6%. The Japanese yen fell 2.2% against the U.S. dollar since the Bank of Japan is not expected to tighten monetary policy in the foreseeable future.
  (GTMA P. 69, 70)
• Supply side issues continued to push oil prices up in October. WTI crude rose 6.9% to USD 83.7 per barrel in the month. A pick up in seasonable demand as the northern hemisphere enters winter is also pushing up demand expectations. Gold prices rose by 1.5% as inflation expectations rose throughout October.
  (GTMA P. 72-74)