How to position your portfolio as global equities head for a correction
Bond valuations remain much more attractive than equities. Investors should manage their equity exposure carefully, while paying more attention to fixed income
GLOBAL equities – represented by the MSCI AC World Index – fell by 3 per cent in August, following a strong rally earlier this year. This was largely driven by a pullback in US equities as the 10-year Treasury yield rose. At the same time, China’s economic woes have rippled through to the rest of the world, snapping investor appetite for risk globally.
In August, the US Federal Reserve also concluded its annual symposium in Jackson Hole, where Fed chair Jerome Powell reiterated that the Fed’s job of fighting inflation is not done yet.
US inflation remains persistent. The Fed is most focused on core inflation measures which strip out the volatile energy and food prices, which have moderated in recent months. But core inflation is still a far cry from the Fed’s 2 per cent target.
We foresee that the decline in inflation will not be smooth. The labour market, with unemployment rate at a healthy 3.8 per cent in August, is not cooling as fast as the Fed would like and appears to be at a level inconsistent with inflation coming down to 2 per cent on a sustained basis.
Furthermore, US economic growth has turned out to be more resilient than expected, fuelling optimism over the prospect of a soft landing. We believe this narrative is inconsistent with market expectations of a rate cut in the first half of 2024.
A resilient economy comes with risks that inflation could reaccelerate, underscoring the view that rate cuts are premature, and it is still not entirely clear that the Fed is done hiking. The Fed should have greater confidence to keep rates at restrictive levels for as long as possible until inflation is on a solid downward trend.
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Fixed income more and more attractive
The higher-for-longer interest rate environment means the fixed income asset class will continue to provide investors with opportunities to earn significantly higher yields.
The 10-year Treasury yield edged to its highest level in 16 years on concerns over higher rates and fears that Japanese investor demand for US Treasuries may wane given greater upside to Japanese government bond yields. Meanwhile, the yield on the two-year Treasury held at around 5 per cent.
Consequently, bond valuations remain much more attractive than equities, despite the recent correction in equity markets. On a relative basis, the spread between earnings and bond yields has narrowed substantially, reaching the lowest points on record since 2007. This suggests that investors are poorly compensated for taking on equity risk.
Coupled with the uncertain macroeconomic backdrop, we believe a more defensive positioning in our portfolios is warranted at the current juncture. We continue to overweight fixed income relative to equities, with a preference for high-quality segments of the fixed income market.
A short duration exposure still make sense for us. We see the potential for long-term yields to move up further as markets continue to underestimate the persistence of inflation.
China a value trap
In a stark contrast to the rest of the world, China has continued to cut rates to prop up a stalling economic recovery. It surprised markets with a series of rate cuts in August, after economic data pointed to rising deflationary pressures and weak credit growth. Moreover, in the latest attempt to boost the struggling stock market, China also halved the stamp duty on stock trading.
Could this help to pull the Chinese economy and its equity market out of a dire state? We think not.
The real cost of borrowing in China has been rising due to falling inflation, suggesting that deeper cuts may be needed. Rate cuts alone are also insufficient to fuel a genuine economic recovery. Meanwhile, debt-laden local governments mean that China does not have the fiscal capacity to roll out a “bazooka-style” stimulus, contrary to investors’ hopes.
In addition, there are lingering long-term structural issues to worry about. China’s embrace of a top-down state-controlled economic growth model will likely usher in a low-growth period, risking the long-term profitability of private companies. This is bad news for China’s equity markets. This is not something that a cut in stamp duty can solve, given that share prices are driven by long-term earnings expectations.
Overall, China’s problems are structural, with no easy fix. While the equity market is no doubt cheap by historical standards, we believe there are no positive catalysts on the horizon that can drive a re-rating. Investors should require a greater margin of safety, or risk falling into a value trap.
Hunting for opportunities
On the whole, we think that it is prudent for investors to manage their equity exposure carefully. Given that valuations of US growth stocks are becoming increasingly expensive, we recommend a quality or value tilt through instruments such as the JPMorgan Funds – US Value A (acc) USD or JPMorgan US Quality Factor ETF.
Beyond that, we are positive on markets such as Japan, Singapore and South Korea. In particular, growing momentum for corporate reforms and the potential to re-emerge as a semiconductor powerhouse paints a rosy long-term picture for Japanese corporates and the economy. Furthermore, the case for policy normalisation has strengthened, lending support to value outperformance.
Finally, investors should pay more attention to fixed income as higher-for-longer rates will keep this asset class attractive. High-quality, short duration bonds are a sensible allocation, given that the Fed is unlikely to pivot to rate cuts so soon.
The writer is an assistant manager with the research and portfolio management team at FSMOne.com, the B2C division of iFast Financial. The latter is a subsidiary of mainboard-listed iFast Corporation.
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