Upgrading Asia amid a divergence in monetary regimes

"BEWARE the Ides of March." (Julius Caesar, by William Shakespeare)

This year's extreme market volatility foreshadows expectations that the FOMC meeting on Mar 15 and 16 will mark an inflection point for US interest rates, prompted by urgency to combat rising inflationary pressures as labour conditions normalise.

If the pandemic era were a play in three acts - starting in March 2020, 2021 and 2022 - we witnessed the initial devastating blows dealt by the disease, followed by swift action by global central banks to balance healthcare and economic priorities. As the curtain falls on easy, accommodative policies in this final act and the world returns to reflationary mode, the spectre of rising inflation is taking centre stage.

The US Federal Reserve, along with other global central banks such as the Bank of England, European Central Bank and Monetary Authority of Singapore, are increasingly hawkish on monetary policy, leaning towards rate hikes and quantitative tightening to combat inflation.

While armchair critics may diagnose these moves as policy mistakes, we have sympathy for the "long and variable lags" (described by Milton Friedman) before monetary policy takes effect. Policy makers need to balance inflationary risks against a complex web of unintended outcomes in the labour market and real wages, and the uneven economic impact on an increasingly dysfunctional global economy, whose previous playbook of free markets has been distorted by geopolitical, technological and Covid-19 related disruptions.

Investors are now grappling with the withdrawal of extraordinary policy support, as rising interest rates hurt income-oriented and longer-dated assets, such as 10-year US Treasuries (the yields of which rose from 1.5 per cent in January to 1.9 per cent), long duration corporate bonds, and growth stocks - which were at the epicentre of the recent market volatility. Emerging market credit was down about 2 per cent in January, while US investment grade and high-yield credit fell by over 3 per cent.

As liquidity from record levels of money supply and low interest rates is withdrawn, we can expect further volatility in capital markets and digital assets, whose prices were boosted by cheap leverage.

At Bank of Singapore, we expect the Fed to end asset purchases and raise interest rates by 25 basis points per quarter this year starting in March, followed by a reduction of its balance sheet, or quantitative tightening starting May 2022. Developed and emerging markets are also unwinding policy support to keep pace with the changes in global financial conditions and keep domestic inflation in check.

The market's recent abrupt and violent adjustments were exacerbated by both liquidity and technical factors, and should not derail the broader post-pandemic bull market in equities.

 Asset Allocation: Overweight equities, but shift preference to Asia

We expect 2022 to remain a year of above-trend economic recovery with global growth of 4.7 per cent, despite Omicron-related disruptions. Hence, we adjusted our asset-allocation strategy to maintain an overweight stance in equities while dialling back on fixed income to neutral position.

Equities will be well supported by rising global output and earnings, despite heightened volatility. History has shown that post-recession equity bull markets do not end with the first hikes of the interest rate cycle.

As Asia's post-pandemic recovery is well underway and valuations are undemanding, we shifted our preference from US to Asia ex-Japan equities, especially China, as they offer investors a more attractive risk-reward profile within a diversified balanced portfolio. The MSCI Asia ex-Japan index trades at valuations of FY22 P/E ratio of 13.7x (which is 0.6 standard deviation above a 5-year average) compared to its peak valuation of 17.6x P/E in early February 2021.

China recently signalled a clear shift towards outright policy loosening - in contrast to the monetary tightening bias in other major developed economies - announcing its first policy interest rate cut since April 2020. Chinese equity valuations are also undemanding compared to the US, as the 12-month forward P/E multiple for China is close to its 10-year average, while that for the US is 1-standard deviation above.

Since early January, sector rotation in anticipation of higher rates has hurt relatively higher-multiple technology growth stocks; energy and financial sectors have maintained their market leadership from last year. Our value-cyclical tilt focuses on companies that enjoy longer-term structural tailwinds such as industrial automation, digitisation, innovation and building climate resilience. Within technology, we are selectively stock picking to identify attractively valued earnings compounders with more mature cash flows and earnings.

We adjusted our fixed-income allocation for Emerging Market High Yield from Overweight to Neutral amid rising rates and a lack of supportive technical factors. We remain selective in Chinese corporate bonds amid expectations of fine-tuning measures to stabilise the property sector in the second half of 2022, relative to Latin America and Central and Eastern Europe, Middle East and Africa (CEEMEA).

Positioned in 2022

Investors should refocus on building portfolio resilience against seismic shifts in inflationary and geopolitical risks, digital innovation and climate change.

• Volatility: We see significant scope for volatility amid the hawkish shift towards less accommodative macro policies worldwide. Russia-Ukraine geopolitical risks and other tail risks add to market uncertainties. Investors should maintain sufficient liquidity to weather rising volatility while accessing suitable alternatives to diversify portfolios. Alternative assets such as hedge funds, private equity/debt and real estate can provide a diversified source of returns for investors' portfolios.
• Valuations: As correlations between asset classes and among sectors fall, investors will focus on alpha generation from areas of relative value to access investment returns. In the US, the potential for a more pronounced rate-hike cycle could present headwinds to valuation multiples. We see a more conducive backdrop for Asian equities ahead, supported by monetary policy easing in China. Valuations are also more attractive. 
•  Vulnerability: Portfolio resilience will be critical in 2022 amid inflationary risks, potential geopolitical flare-ups, growth shocks and climate policy changes. Investors should guard against such areas of vulnerability in portfolios - including excessive leverage, concentration risks in single-country or single-asset classes. As governments get serious about climate policies, which may include punitive carbon taxes on industries and companies, investors should be selective in holding securities of companies which are vulnerable to environmental, social and governance risks.

Investing is not a sprint, but a marathon. Entry opportunities in medium-term investible themes such as Web 3.0, China's common prosperity and climate resilience have arisen from short-term market dislocations.

Investors can adjust core portfolios to tap diversified sources of returns via asset classes, geographical and sector rotation in both public and private markets. Augment this by allocating to differentiated portfolio management styles and suitable use of option payoffs.

The writer is chief investment officer and head of portfolio management and research office, Bank of Singapore