As the US Federal Reserve (US Fed) hiked its rates by 75 basis points for the third consecutive quarter after the Federal Open Market Committee (FOMC) meeting on Sept 21, UOB Kay Hian analyst Jonathan Koh sees that the “ferocious rate hikes” have almost reached a “climax”.
“Based on the Fed’s dot plot, the median projected path for Fed Funds Rate would hit 4.4% by end-2022 and 4.6% by end-2023,” Koh writes in his Sept 27 report. “The projection is expected to lead to continued steep rate hikes of 75 basis points on Nov 2 and 50 basis points on Dec 14, bringing the Fed Funds Rate to 4.25 by end-2022. The rate hikes are front-loaded in 2022 and the intensity of rate hikes is expected to be modest in 2023.”
While Koh expects the next two rate hikes to be steep, he surmises that the 4QFY2022 could be the “last quarter of pain”. “The rate hikes are front-loaded in 2022 and the intensity of rate hikes is expected to be modest in 2023,” he says.
In his report, Koh notes that the Fed is primarily concerned that inflation remains elevated, driven by imbalances between demand and supply, and points at Fed chair Jerome Powell’s quote to quell inflation and “keep at it until the job is done.”
Based on economic projections submitted by FOMC participants, US GDP growth is expected to slow to 1.2% and the unemployment rate should rise to 4.4% in 2023.
Despite this, Koh thinks that a US recession is not inevitable. He says the strong labour market increases the likelihood of a soft landing for the US economy.
On a separate note, he points out that an inverted yield curve foreshadows the risk of a potential US recession. The US yield curve flattened in 1H2022 but inverted in 3Q2022.
Furthermore, yields for 2-year US government bonds shot up by 125 basis points in 3Q2022, outpacing the increase of 67 basis points for 10-year US government bonds. The 10-year-2-year term spread has turned negative since July 2022 and is currently -0.52%.
However, Koh sees that the current short-end of the yield curve implies forward short-term interest rates at 4% for one year, 4.5% for two years and 4.3% for three years, indicating a possibility of rate cuts in 2024.
‘Overweight’ on S-REITs
To this end, Koh has kept his “overweight” rating on the Singapore REITs (S-REITs) sector with “buy” recommendations for most of the REITs under UOB Kay Hian’s coverage.
The analyst has, however, cut his target prices on the REITs by an average of 7% as the sector is currently weathering headwinds from the higher interest rates (see table below).
“S-REITs are not out of the woods yet, but the recent easing of inflationary pressure provides some respite. They own the underlying real estate across various asset types, which provide a hedge against inflation,” he writes.
“S-REITs provide an attractive distribution yield of 5.90%, which is 0.9 standard deviations (s.d.) above long-term mean. Downside is limited to a correction of 10.1% if yields spike to 2 s.d. above mean at 6.56%,” he adds.
In addition to the lowered target prices, Koh has lowered his distribution per unit (DPU) forecasts by an average of 2% due to the higher cost of debt.
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“Yield for [the] Singapore 10-year government bond has increased 35 basis points to 3.33% in 3QFY2022. We have likewise adjusted the risk-free rate for our dividend discount model (DDM) valuation from 3.0% to 3.25%,” he says.
Among the REITs, Koh likes hospitality and retail REITs as reopening plays, and logistics and data centre REITs as new economy plays.
Koh’s “top buys” are the newly-minted CapitaLand Ascott Trust (CLAS), formerly Ascott Residence Trust (ART), Frasers Centrepoint Trust (FCT) and Lendlease Global Commercial REIT (LREIT) with target prices of $1.29, $2.56 and 91 cents respectively.
Target prices for other top buys, Mapletree Industrial Trust (MINT) and Mapletree Logistics Trust (MLT) are at $3.12 and $1.94 respectively.
As at 4.38pm, units in CLAS (previously ART), FCT, LREIT, MINT and MLT are trading at 98 cents, $2.15, 77 cents, $2.37 and $1.56 respectively.