Prepping your portfolio to ride through the seasons 

IS WINTER coming? This appears to be the consensus of the World Bank and International Monetary Fund (IMF), who have given bleak assessments of the global economy this year.

The IMF’s latest World Economic Outlook report released in April this year struck a somber tone, with the organisation tempering its forecast for global growth in 2023 to 2.8 per cent from 2.9 per cent previously, due to tighter global monetary conditions.

More ominously, the report also warned of a “severe flare-up of financial system turmoil that could slash output to near-recessionary levels’‘.

The World Bank also drew attention to dark clouds gathering on the horizon. Group president David Malpass said earlier this month that turmoil in the banking sector and higher oil prices could put downward pressure on global growth in the second half of 2023.

The IMF and World Bank’s forebodings are echoed by market watchers and media outlets, making a strong case that the world is inching into a recession (or “winter”). Faced with such dire portents, how should investors act? Let us look at some numbers to make our analysis.

Economists often look to an indicator called the Composite Leading Index (CLI), which is derived from various coincident and leading indicators, to get some sense of future economic activities and anticipate turning points of growth cycles.

As an example, Singapore’s CLI, compiled by the Department of Statistics, is computed using nine economic time series including total new companies formed, wholesale trade business expectations, US manufacturing Purchasing Managers Index (PMI), et cetera.

The CLI shows that gross domestic product (GDP) is set to decline by 5.4 per cent in the second quarter of 2023, following the Ministry of Trade and Industry’s April report of a 0.1 per cent year-on-year growth in the first quarter.

The Monetary Authority of Singapore (MAS) also kept to its existing policy stance during its most recent policy meeting, signalling confidence that core inflation will “ease materially by end-2023” from the past few instances of monetary tightening, while supporting growth by not further appreciating the Singapore dollar.

In fact, MAS warned: “With intensifying risks to global growth, the domestic economic slowdown could be deeper than anticipated... Prospects for Singapore’s GDP growth this year have therefore dimmed”.

But it is not just Singapore that might be slowing down. We examined the CLI of 39 economies and found that 92 per cent also expect a slower second quarter.

Many economies rely on their manufacturing sectors as a ladder to economic prosperity. In Singapore, we have experienced first-hand how manufacturing has helped us become an advanced economy, with one of the highest per capita GDP among the non-oil producing economies.

However, the manufacturing sector is also more volatile and exposed to the ebbs and flows of global consumption and investment cycles. For now, we need to brace for further slowdown.

Our detailed survey of the manufacturing PMI of 41 economies and regions showed that 60 per cent reported a contraction last month. Back in November 2021, only 12 per cent reported a contraction. The world is certainly slowing down a lot more, and the manufacturing sector’s performance acts as a harbinger of upcoming growth prospects.

The good news for Asia is that China has just reopened and is experiencing a strong wave of domestic consumption due to pent-up demand. China is at the early part of their business cycle – akin to entering spring – while the rest of the world is moving towards winter.

China’s latest PMI statistics showed an expansion in its services sector, a heartening development as the industry constitutes more than half of the country’s GDP. However, a contraction in manufacturing shows that the icy reach of an impending winter has managed to infiltrate even China’s spring sojourn.

The higher interest rate environment is also causing a global consumption chill, with consumers preferring to squirrel away their money into deposits with high interest rates than spend it. Corporates are also more restrained with regards to expansion and investment, as borrowing costs are high during this part of the business cycle.

In the US, banks have tightened credit to corporates as well – seemingly like autumn. This is precisely what policymakers want to achieve – reduce demand-pulled inflation, by making it painful to spend and borrow money.

In April, we downgraded equities to underweight, reflecting our expectations of further earnings downgrades and to remind investors of prudence as we prepare for winter.

However, underweight does not mean zero weight. Sector rotation is key.

It is still important to hold equities in a portfolio even during a recession. Investors often err on the safe side, waiting till the coast is clear and the economy is showing signs of recovery to start picking up equities. This is often too late. We recommend these portfolio actions to weather the cold:

First, cut exposure to cyclical stocks (for example, energy, financials, industrials, materials and real estate), as they are likely to be exposed to earnings risk and would probably underperform.

Second, increase exposure to interest rate-sensitive growth stocks (for example, technology and communication services). These should finally do well as the worst of growth sector de-rating is likely behind us. Moreover, expectations of Federal Reserve rate cuts (to cushion against a hard landing) will be supportive of growth stocks.

Third, stock up on defensive stocks (for example, healthcare, consumer staples and utilities), as their stable and consistent returns will act as a bulwark against the encroaching winter.

Fourth, we like emerging markets, particularly Latin America, Asia and Asean, as these regions will likely fare better than the developed Western economies in the event of a global slowdown.

Meanwhile, having some fixed income in the portfolio is like having an insurance plan, offering protection before illness strikes. We favour government bonds and investment-grade corporate credits for their resilient yield carry and potential capital gains when winter arrives.

Alternative assets such as hedge funds and private markets should also feature well in a portfolio as they provide uncorrelated returns. Precious metals (for example, gold) allocation also provide a good hedge in the event of an equity sell-off.

The world is moving slowly but surely into the winter of the current business cycle that started with the recession in the first half of 2020. This will be one of the shortest business cycles, at around three to four years. We are beyond discussing when we will be going into a recession, but are focusing on how we can protect our portfolios as we are entering one.

In 1962, a year after the US emerged from a recession, President John F Kennedy said in his address to Congress: “Pleasant as it may be to bask in the warmth of recovery... the time to repair the roof is when the sun is shining.”

As winter once again approaches our shores, we would do well to heed his words.

The writer is investment strategist, UOB Private Bank.