The Year-End Investment Forum on Dec 3, titled Investing in the Shadow of the Fed — sponsored by TD Ameritrade and organised by The Edge Singapore — attracted a packed house at One Raffles Quay’s The Executive Centre, which was unexpected given it was held on a Saturday morning.
The speakers at the event were Suan Teck Kin, UOB’s executive director, head of research, global economics and market research, with a sobering message in his presentation Impact of Interest Rates; TD Ameritrade’s senior trade desk manager Leonard Eng took A Dive Into Portfolio Solutions Going Into a Mild Recession; while Alétheia Capital’s head of consumer and internet Nirgunan Tiruchelvam gave an interesting take on Sectors to Watch for 2023.
For investors, Suan simplified the Federal Reserve’s (Fed) actions and objectives with a sobering message that the Federal Funds Rate (FFR) set by the Fed are likely to move higher and is unlikely to fall next year based on the data. As a result, riskfree rates, which have receded in the last two weeks of November, are set to rebound.
The actions of the Federal Reserve and the words of its chairman Jerome Powell were and are likely to remain driving factors for markets for the next 18 to 24 months. “For the Fed, there are only two objectives; one is to keep the labour market functioning properly, such as making sure that the unemployment rate is at an acceptable level, and at the same time maintain the inflation rate at an acceptable level,” Suan says.
The Fed’s blunt tool is interest rates to manage unemployment and inflation. For November, the unemployment rate in the US stood at 3.7%, which is about the lowest that it can get. During the pandemic, unemployment rose as high as 13% in 2Q2020.
However, Suan says the economic recovery in the US has kept the unemployment rate at the lowest on record. “We were already telling our clients towards 2H2021 to ‘get ready’ for the Fed to move. But the Fed didn’t do anything,” he adds.
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In his view, the Fed waited too long until it was too late and rushed to raise rates. As at December this year, the Fed is probably still catching up because inflation continues to stay elevated. In June, inflation in the US — as measured by the consumer price index (CPI) — hit a 40-year high of 9.1% (y-o-y). Since then, CPI has decreased but remains stubbornly high. As at October, CPI stood at 7.7%. On the personal consumption expenditure front (PCE), June peaked at 7% (y-o-y). Since then, PCE has eased to 6% as at October.
Suan cautions that investors should look at the month-on-month number because this is what the Fed does. Every month, the m-o-m number was historically 0.2%. During the pandemic, it was 0.1%. In 2021, this m-o-m figure started rising, jumping to 0.5% up to June this year. The number for October was 0.3%.
“If the trajectory is 0.3% every month, by the end of next year, inflation will be 3.7%,” says Suan. The Fed’s guidance is for inflation to be 2%. On the other hand, if the m-o-m inflation figure accelerates to 0.6%, then inflation at the end of 2024 could be as high as 7.4%.
The US economy will likely tip into recession at this level because the Fed will raise rates higher than the expected 5% plateau. UOB is forecasting a 50 bps hike this month and two hikes in 1H2023 of 25 bps each, which would take FFR to 5%.
“It’s very important to monitor the month-on-month change because that determines the view on the FFR,” Suan adds. Based on his projections of the trajectory of the unemployment rate, the US is likely to enter a recession in 1H2023. “If the jobless rate moves to 4.5%, the US will enter into a recession sometime in the middle of next year.”
High probability of recession
TD Ameritrade’s Eng also believes the US will experience a mild recession in 2023. According to Charles Schwab’s 4Q2022 traders’ survey, the most number — around 43% — expect a recession and for it to last six to 12 months.
Eng has some suggestions for investors if the US enters a recession (note that the probability is high, but there is no certainty of a recession). He suggests that investors heed how American entrepreneur Mark Cuban protected his investment just ahead of the dotcom collapse. In 1999, Cuban sold his company to Yahoo for US$5.7 billion in part exchange for Yahoo shares.
As a visionary, Cuban saw two challenges for his investment in Yahoo, a dot-com bust for an overvalued Nasdaq and the popularity of Google as a search engine in 1998 (with the potential to displace Yahoo). Cuban entered into a collar trade with Goldman Sachs.
A collar is an options strategy that involves buying a downside put and selling an upside call implemented to protect against large losses and limit significant upside gains. The protective collar strategy involves a protective put and a covered call.
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Eng uses a hypothetical example with Microsoft to illustrate a collar. Using a chart, he points out that losses are limited if the market falls. On the other hand, if the investors sell the call, there could be a limited profit.
“First, you should have a position. Second, you are aware of the impending downturn. Third, you have the intention to make a profit. With all three factors, that’s what Cuban had ready when he crafted the collar.”
He also suggests that investors stick to high-quality stocks: “Companies with low debt, positive earnings, strong cash flow and low volatility tend to outperform when recessions hit, and investors turn to businesses with ample financial cushions”.
He adds that lower-volatility sectors, defensive sectors are consumer staples, healthcare, and utilities, tend to be less volatile than the broader market and therefore have more significant potential to outperform when returns go negative.
Stay with cash-generating FMCGs
Tiruchelvam starts his presentation by saying he wants to talk about three objects that arose from three trends he sees for 2023. “More people will go to the office because the pandemic will ease the restrictions. Working from home will become less common.”
The second is that more people will be travelling. In 2019, visitor arrivals to Singapore stood at close to 20 million. For the year to September, visitor arrivals to Singapore were a mere five million. The 20 million visitor arrivals represent potential for Singapore, adds Tiruchelvam.
“The third, because of the higher interest rate levels, people will need to look for steady cash-generating and reliable investment ideas.” The three objects — the suitcase, the razor and a bar of soap — represent the themes around travel, reopening and investing in a higher interest rate environment with cash-generating companies.
For the travel theme, travellers will either dust off old suitcases or buy new ones. “A first object is an object that we use when we go on holiday, and it’s the suitcase. You would be surprised to hear that it was only in the late 1980s that people put wheels at the end of a suitcase,” Tiruchelvam says. Samsonite, the most well-known travel brand, is an American luggage manufacturer on the Hong Kong Exchange.
He had the razor as his second object for the reopening theme. The razor represented the going-back-to-office theme, as his thesis is that men are likely to shave at least once a week as they return to the office. He could have quickly suggested that the ladies are likely to revert to habit and use more cosmetics as they get out and about.
In this case, the largest cosmetics companies are L’Oreal and Estee Lauder. Kao and Shiseido are among the top 10 global cosmetic companies and are popular among Asians. Old names such as Coty and Revlon are also listed on the New York Stock Exchange. While Coty is relatively more minor than L’Oreal and Estee Lauder, the popular Max Factor brand is owned by Coty.
The final object was a bar of Lux soap. Lux is a brand owned by Unilever, one of the largest fast-moving consumer goods (FMCG) companies. Lux is usually marketed primarily in emerging markets such as Brazil, India, Thailand and South Africa. The bar of Lux soap represents cash-generating FMCGs.
Based on data compiled by Bloomberg, the Stocks to Watch in 2023 table below indicate that Proctor & Gamble (P&G) and Johnson & Johnson have the highest interest cover ratios, operating margins, and the lowest net debt to equity ratios.
As for the razor, Tiruchelvam shows a photo of King Gillette. “He was an entrepreneur about 100 years ago. His great invention was to create the safety razor. He realised that if he could provide a razor that could be used regularly and where the blades would be disposable, he would be able to create a model where he subsidised the cost of the razor by making money on the blades. His product is used all over the world. The Gillette razor is the Rolls Royce of razors.”
Men today have Gillette razor kits which are popular across the generations, from Generation Z to millennials and their parents, the baby boomers. In 2005, Gillette was acquired by P&G, one of those moves that made Warren Buffett even wealthier. With P&G, investors get both the reopening theme and a cash-generative FMCG as it also makes a lot of products on the supermarket shelf, such as Ariel, Tide, Downy, Crest, Oral-B, Febreze and Ambi Pur, to name a few.
