Global equities have run up recently; should you chase the rally?

GLOBAL equities have had a good start to the year. As at end-May, the MSCI AC World Index has delivered returns of more than 10 per cent in Singapore dollar terms.

The rally has driven equity valuations further into the expensive territory, as markets seemingly ignored the risks of slowing growth, elevated inflation, higher-for-longer interest rates and the recent US bank failures. Investors who are planning to chase the rally should think twice.

The US Federal Reserve has been locked in a battle against inflation since it started raising rates back in March 2022. More than a year later, the fight is far from over.

Inflationary pressures – as measured by the consumer price index (CPI) – have eased, from last year’s peak of 9.1 per cent to 4.9 per cent in April 2023.

But prices are still not falling fast enough for the Fed to declare victory. Meanwhile, the core personal consumption expenditure (PCE) price index – the Fed’s preferred measure of inflation – rose by 4.7 per cent in April, accelerating from 4.6 per cent a month earlier.

The Federal Reserve Bank of Atlanta’s Sticky-Price CPI, a measure of inflation for goods and services whose prices are hardest to change, also shows that inflation remains stubbornly high, with a reading of 6.5 per cent in April.

For context, the Atlanta Fed estimates that in order to be consistent with the Fed’s target of 2 per cent for core PCE, sticky inflation has to be approximately 2.5 per cent. As it stands, inflation is still a long way from the Fed’s target.

Markets, however, seem to be under the impression that the Fed will get the job done quickly. The one-year breakeven inflation rate – a market-based measure of expected inflation – is currently at 2.6 per cent.

We think that inflation expectations are overly optimistic. We believe that inflation is going to take much longer than markets expect to come back down to 2 per cent.

Here are a few reasons why.

For starters, the US labour market remains extremely tight. In May, jobs growth rose by a massive 339,000, easily beating the consensus forecast of 190,000 jobs. Right now, there are more than 1.5 jobs available per unemployed person in the US.

The shortage of workers has led to robust wage growth, with hourly wages rising by 6.1 per cent in April – again a level not consistent with the Fed’s 2 per cent inflation target.

We also have reasons to believe that inflation is structural in nature, and that the world is moving into a new regime where structural forces will lead to a more persistent rise in inflation in the years ahead.

Apart from the tight labour market conditions, inflation is also driven by other factors, such as supply-driven shortages in commodity markets and deglobalisation.

These days, many countries are moving away from fossil fuels towards renewable energy due to environmental concerns. However, because the increase in renewable energy has not kept pace with rising energy demand, fossil fuels still account for roughly 80 per cent of the world’s energy needs today.

Unfortunately, because of structural underinvestment in upstream oil and gas assets (due to the green transition), the supply of fossil fuels has been constrained. That sets the world up for an even tighter energy market in the years ahead.

The green transition will also contribute to longer-term inflation by creating a huge boom in demand for metals that underpin everything from electric cars to renewables. The supply of these metals is inadequate for future needs.

Lastly, geopolitical tensions, such as those between the US and China, will likely result in less international trade and thus higher prices.

Beyond the US, inflation across the world remains elevated. Countries in the European Union, UK and even Singapore have reported higher than expected prices pressures as of late.

Odds of recession now greater

To tame inflation, central banks across the world have resorted to raising interest rates.

This global monetary tightening is now increasingly synchronised around the world, and nearly every major economy has hit the brakes. Policy has never tilted so overwhelmingly towards rate rises in the past five decades.

Take the US, for instance. The Fed has lifted policy rates by a total of 500 basis points in a span of 14 months. This is roughly equivalent to a rate of change of roughly 35.7 bps each month. Compared to previous rate-tightening cycles, the current cycle is way more aggressive than anything we have seen since 1980.

Generally speaking, tighter monetary policy puts the brakes on consumer spending and business investment. The reduction of aggregate demand in the economy leads to lower growth, and in most cases, a recession.

The track record speaks for itself.

Out of the seven rate-tightening cycles by the Fed since 1980, six ended in a recession. Given how much more aggressive the current cycle is, along with the Fed’s repeated warnings that rates would be higher for longer, we think it is only a matter of time before a recession hits.

The recent banking crisis has also added a fair bit of uncertainty to the financial sector, especially the smaller regional banks which have experienced large deposit outflows.

Banks are likely to become even more conservative in lending, amid rising funding costs. They would seek to preserve liquidity in the event of deposit withdrawals. This should lead to lower loan growth and tighter financial conditions which will weigh on economic activity.

Asset allocation

With the recent outperformance of equities, investors may be tempted to chase the rally for the fear of missing out. But at times like these, we think it is prudent for investors to manage their equity exposure carefully.

Growth stocks in particular tend to be more vulnerable in a recessionary environment. To that end, investors who still wish to invest in equities would be wise to consider a more defensive approach, such as overweighting value or quality stocks and an underweight on growth stocks.

With the expectation that of higher-for-longer inflation, some exposure to commodity-linked equities may be beneficial as well.

On the asset-class level, we continue to reiterate our preference for fixed income over equities, particularly higher-quality bonds and short-duration bonds. We like investment-grade bonds over high-yield bonds as a more defensive positioning may be important as a recession looms.

Our preference is for short-duration bonds. Short-term bond yields have moved significantly higher compared to long-term yields. This allows investors to receive higher returns without having to take on greater duration risk.

The writer is an assistant manager of the research & portfolio management team at FSMOne.com, the B2C division of iFAST Financial Pte Ltd. The latter is the Singapore subsidiary of SGX-listed iFAST Corporation Ltd