- The main challenges to our current asset allocation views include stronger-than-expected growth, or stubborn inflation, a deterioration in U.S.-China relations as well as risk-off sentiments that supports the U.S. Dollar as a safe haven currency
As we discuss and share our economic and asset allocation view with the release of the 2Q 2023 Guide to the Markets Asia, Australia, and Japan, we note that our view is aligned with that of many Chief Investment Officers (CIOs) and experienced investors. This includes our preference for high quality fixed income, caution against U.S. equities, optimism on Chinese and selected Asian markets, and a bearish view on the U.S. dollar (USD). While having a consensus view does not automatically imply we are wrong, it is worth challenging these views by considering their vulnerabilities and how likely this would take place.
High quality fixed income is vulnerable to stubborn inflation
The first consensus view is high quality fixed income, which is part of many CIOs’ core views. The threat of an economic recession in the U.S., and the prospects of monetary easing, imply that duration risk could be a tailwind, instead of last year’s headwind. Corporate credit spreads could widen, and this would penalize corporate debt with lower credit ratings.
What could go wrong with this view? Stronger-than-expected growth performance in the U.S. or inflation rebounding could be a threat to this view. In this scenario, U.S. Treasury yields could re-test the 2022 highs, as the Federal Reserve’s (the Fed) policy rates stay higher for longer. This would also imply that high yield corporate debt can maintain its current credit spread, and its higher coupon could allow for outperformance against government bonds and investment grade corporate debt.
Inflation in the U.S. is rolling over, as illustrated by the March Consumer Price Index data. While consumer spending is supported by a robust job market and a relatively low debt burden, the appetite to spend by the corporate sector and the real estate market are all impacted by higher rates. The tightening of bank lending could exacerbate this situation.
U.S. equity recovery could be swift if the Fed blinks
Our conservative view on the U.S. equity market is based on the fact that equity valuations are still above the level consistent with a slowing economy. Earnings expectations are also relatively optimistic given the economic challenges ahead. This implies that both would need to be corrected to a more reasonable level.
Similar to our view on high quality fixed income, a better-than-expected growth scenario would provide support to the equity market. In addition, the Fed reacting quickly to the first sign of an economic slowdown by easing monetary policy, even if inflation remains above target, could also breathe fresh life into equities. Lower rates would boost equity valuations, allowing for a re-rating, as well as stimulate the economy, which could provide the needed boost to earnings.
However, the Fed remains locked into fighting inflation, at least for now. While the Federal Open Market Committee meeting minutes show a few members have advocated a pause in policy rates given the banking sector's turmoil, no one seems to think a rate cut is warranted. We still believe that unless the economy is facing a hard landing scenario, the Fed would wait to loosen monetary policy until inflation is closer to its objective.
Investors could stay cautious on China due to geopolitical uncertainties
China’s economic recovery and policy support from the authorities contrast strongly with our assessment of the U.S. economy. Given reasonable valuations, we believe China’s corporate earnings could outperform the U.S. in 2023, and this should translate into Chinese market outperformance as well (see Exhibit 1).
Exhibit 1: Relative performance of S&P 500 and MSCI China
Year-over-year changes in trailing EPS and price index
However, one pushback we often hear is the ongoing tension between Washington and Beijing. While it is impossible to quantify how geopolitics would impact market performance, some of the trade restrictions introduced by both sides do have an impact on the economy and corporate earnings outlook.
The strategic competition between U.S. and China is likely to be a longstanding feature. We see some sectors that are less exposed to the threat of trade restrictions, such as those serving Chinese or Asian consumers. Moreover, Beijing is also developing new industries, some of which to reduce import dependence, and others to meet the challenge of carbon neutrality. These can still offer investors an opportunity. Also, investor position on Chinese equities remains light at this stage.
Could the USD be a safe haven currency once again?
Our bearish view on the USD is based on the fact that it is still overvalued. USD interest rate advantage over other major currencies should be eroded by the end of the Fed’s hiking cycle, while the euro area and the UK could have more room to tighten. The outperformance of the U.S. economy compared with other developed and emerging markets in the past two years is also coming to an end.
What could change? The USD typically outperforms when the U.S. economy is really strong, or when there is a risk-off event that prompts investors to seek refuge in safe havens, such as the USD, Japanese yen, or Swiss franc. We have already argued that the U.S. economy is losing momentum. So the first scenario is unlikely. On the possibility of being a safe haven currency, it should be noted that the USD did not notably appreciate during the March banking sector stress. This could be because the problem takes place in the U.S. The nature of the risk off event could also determine whether the greenback is a potential beneficiary.