THE sell-down of risk assets in 2022 marked a watershed moment for financial markets. Never have equities and bonds corrected so acutely in tandem – not during the 1970s recession and certainly not during the Great Financial Crisis (GFC) of 2008. While it is easy to attribute this volatility to the Russia-Ukraine crisis and China’s Covid-19 lockdowns, clearly, the biggest culprit is the US Federal Reserve.
After being caught wrong-footed in its “transitory inflation” narrative for an unnecessarily prolonged period, the Fed has frantically tried to salvage its credibility through aggressive rate hikes which, inevitably, exported monetary pain to the rest of the world – in particular, emerging markets and high growth equities. While the central bank has since expressed a willingness to downshift to a slower pace of policy tightening, much will also depend on whether the recent softness in CPI (consumer price index) data is sustained.
We expect three things to transpire over the course of 2023.
One, the Fed is set to downshift its monetary policy as economic momentum decelerates. Two, the dollar will peak; and three, a low growth/high inflation environment will persist. Given these dynamics, the trajectory for equity markets will be more complicated and nuanced. With bond yields at above 5 per cent today and equity valuations having mean-reverted, the window is now open to be engaged for the long term, in a multi-asset portfolio of equities and bonds.
We believe it is an opportune time to pursue a 60/40 portfolio strategy. As the saying goes: “Never waste a crisis”. For investors who bemoaned the lack of value opportunities in risk assets previously, the time has come. As painful as 2022’s sell-down has been, it has also surfaced fresh opportunities for investors to construct a traditional 60/40 portfolio (60 per cent equities, 40 per cent bonds) as a great starting point. What is critical is for investors to build resilient portfolios that comprise securities of high-quality companies that demonstrate traits of being income generators, growth enhancers and risk diversifiers.
Investment-grade bonds: income and safety
There is never a better time for investors to buy bonds. With yields at current levels, the bygone theme of “searching for yield” seems like a distant memory now. But apart from the yield/income angle, bonds also provide investors with downside protection given its defensive qualities. This is particularly important with rising recession risks lurking on the horizon.
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Hence, given the favourable risk-reward for bonds, we are upgrading the asset class to overweight in Q1 2023 while staying neutral on equities. The relative attractiveness of bonds is evident in the bond-equity yield gap (bond yield versus equity dividend yield) which is standing at the widest level since the GFC. Within the bonds complex, we favour US Treasuries and investment-grade credit.
Equities: focus on resilience
The trajectory for the S&P 500 will be subject to the cross currents of earnings contraction and valuation expansion in 2023. We maintain a constructive view on technology and communication services. These growth sectors have undergone substantial de-rating as markets have priced in the impact of tightening financial conditions. But we expect the reverse to happen as bond yields moderate over the course of the year. Meanwhile, earnings momentum is expected to stay resilient as these sectors possess strong operating margins. Stay with quality companies such as I.D.E.A. companies representing innovators, disruptors, enablers and adapters.
We maintain preference for US and Japan in developed markets, and China remains an overweight. There is compelling upside potential for China equities to re-rate from current levels, driven by the ongoing introduction of government measures to alleviate key concerns regarding Covid-zero policies, real estate sector problems, and economic goals. These positive catalysts are now falling into place as we had predicted. The market has lauded such moves, as evidenced by recent share price rebounds.
As we reiterate our stance on China equities, the timing has materialised to dollar-cost average. Investment opportunities are emerging as China reopens; we stay constructive on domestic-oriented sectors which are at the forefront of the reopening ripple. These include A-shares, new economy, and e-commerce platforms, China consumer brands, beneficiaries of government fixed asset expenditures, and high dividend yielding financials.
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