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Favour bonds on expectations for recession in 2023

Tong Kooi Ong & Asia Analytica
Tong Kooi Ong & Asia Analytica12/15/2022 12:25 PM GMT+08  • 11 min read
Favour bonds on expectations for recession in 2023
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Around this time every year, we would be inundated with a deluge of broker reports outlining their outlook, focus and strategy for the new year. There will be predictions for the stock-bond markets and year-end targets for the relevant bellwether indices. Inevitably, almost every prediction will be wrong and the ones that come close can be chalked down to pure dumb luck. Case in point, this time last year, the consensus end-2022 target for the S&P 500 index was 5,265 — which is a hefty 32% above where we are right now.

The truth is, no one can consistently and accurately predict the future. But being consistently wrong has yet to deter anyone from trying. And, we have to concede, it feels good and is somewhat entertaining. Hence, we too will jump on the bandwagon and offer our own predictions for the coming year. Though quite frankly, given the magnitude of prevailing uncertainties, it is hard to see beyond the next few months. For followers of this column, this will be our last article for the year but, worry not, we will be back in 2023.

Global economic slowdown and, for some countries, outright recession in 2023

The global economy is headed for a slowdown in 2023 and, for some countries, outright recession. Leading indicators already point to this, for instance the J.P.Morgan Global Composite Output Index signalled contraction in the past four consecutive months. According to the survey, November saw manufacturing output and service sector business activity fall at the fastest rates since June 2020 (see Chart 1). New manufacturing orders contracted sharply, especially in Europe and North America. At the same time, a series of lockdowns across China curtailed consumer spending and disrupted manufacturing output. All of which will create a domino effect in export-oriented Asian economies in terms of trade and capital flows heading into 2023.

Taming supply-shock inflation comes at the cost of a recession

See also: Arguments for keeping domestic interest rates relatively low

This should come as no surprise. We explained why a slowdown-recession is inevitable some months back — in our article entitled “Central banks cannot address supply disruptions, the cause of global inflation” (Issue 1440, Sept 26, 2022) — predicated on the economic principles of supply and demand. You can scan the QR code below to read the full article.

To briefly recap, inflation is running at the highest levels since the early 1980s, initially driven by severe supply disruptions due to pandemic lockdowns combined with surging consumer demand for goods, underpinned by massive fiscal and monetary stimulus. However, what central banks once believed were transitory price increases then failed to normalise after economies reopened, as supply disruptions persisted. This was attributed to myriad reasons including China’s disruptive zero-Covid policy, loss of productive capacities due to business closures and delayed capacity expansions during the pandemic, wide-ranging sanctions on Russia after its invasion of Ukraine, which triggered an energy and food crisis, and, critically, a widespread labour shortage. People left the workforce during the pandemic. Many have yet to return — due to geographical dislocation, caring for family members, lingering health issues, career and behavioural changes, early retirement and so on — and some may never return.

See also: When something is free, you are the product

This is the situation we are now in (see Chart 2). Demand is returning to around pre-pandemic levels (D2 = D0) but aggregate supply remains constricted (S2 still lies somewhere above S0). As a result, inflation is elevated, P2 > P0.

Recent data shows a moderation in goods inflation with production-logistics disruptions on the mend but services inflation — driven by wages and rent-housing price gains — is still too high for comfort. The labour market remains exceptionally tight, as a result of the above-mentioned factors coupled with the secular trend of ageing population and disrupted migrant worker flows. And this shows up in the continued rise in services inflation, which is heavily reliant on labour and wage rates. Services inflation also tends to be far stickier. This is why we think it is premature to expect any near-term reversal of higher interest rates.

In order for prices to fall back to P0, demand needs to drop to Q2 — which is below pre-pandemic levels, Q0. In other words, recession. This is what the US Federal Reserve is aiming for — it is effectively engineering a recession, to bring inflation back under control.

When inflation is caused by excessive demand, the appropriate policy response is for central banks to raise interest rates to lower demand, and cool the overheated economy. Higher interest rates cannot resolve inflation driven by geopolitics and supply constraints. But monetary policies are the ONLY tools central banks have.

In short, the Fed has no choice. It must rein in inflation and, more importantly, inflation expectations — even if at the cost of some economic pain — to retain credibility and ensure future policy effectiveness. Allowing runaway inflation will lead to even greater economic damage down the road. Positively, recent moderation in US Consumer Price Index (CPI) numbers suggests that the Fed’s aggressive stance may be starting to bear fruit.

Inflation for November came in at 7.1%, the fifth consecutive month of declining yearon-year growth after peaking at 9.1% in June (see Chart 3). Stock and bond markets rebounded as investors raised bets that inflation is past its peak and, therefore, the current interest rate hike cycle must be coming to an end, soon. We think so too. As we wrote previously, mathematically, the headline inflation figures should fall given the high base effect (inflation started surging around October 2021). Nevertheless, we think markets are underestimating the Fed’s resolve and, more importantly, the impact of economic slowdown-recession on corporate earnings.

For more stories about where money flows, click here for Capital Section

Stock market is underestimating impact of rate hikes on corporate earnings

While the pace of price gains is slowing, a 7.1% inflation rate remains more than three times over the central bank’s longer-term 2% target. The Fed is unlikely to cut interest rates at the first sign of economic slowdown. Indeed, Fed chair Jerome Powell indicated as much — he would rather do too much than not enough, taking lessons from the painful experience in the 1970s, to ensure inflation stays down. In for a penny, in for a pound.

We think rates will stay higher for longer than the market currently expects. The outlook for inflation is further complicated by worsening geopolitical tension between the US and China, and globalisation — the biggest disinflationary driver over the past two decades — is in reverse. The eventual reopening of China, likely next year, could also recharge commodity, including oil and gas, prices.

For all the talk of recession, current corporate earnings forecasts and stock valuations suggest otherwise. Maybe analysts are in denial and/or are perennial optimists. Earnings are forecast to grow 5.5% in 2023. Net margin is expected to expand to 12.3% — up from the estimated 12% in 2022, and well above the 10-year average of 10.3%. In contrast, US corporate earnings have, historically, contracted during recessions (see Table 2). Earnings also take longer to hit bottom when the Fed is slow to cut rates. This could be the scenario we are looking at this time around — after all, the Fed is engineering this recession, not trying to avoid one.

Stocks have room to fall on earnings disappointment

Weaker-than-expected corporate earnings results over the next few quarters will surely hurt market sentiment and stock prices. According to FactSet, the trailing price-toearnings ratio (PER) for the S&P 500 now stands at 19.2 times and forward PER at 17.1 times (based on prices on Dec 9) — both are well above the lows recorded in previous recessions. The long-term average trailing PER (since 1954) is 17.1 times.

When earnings do come in lower, valuations will rise further. In other words, US stock prices have room to fall. In fact, even if earnings expand marginally, prevailing valuations still suggest limited upside, at least until there is greater clarity on stronger growth. This is the main reason why we have continued to avoid US equities, for now, in favour of Treasuries for the Global Portfolio.

Historically, bonds outperform stocks in the early stages of recessions, given their extremely low risks and fixed income flows. We wrote about this in our previous article “Understanding interest rates, stocks and bond prices” (Issue 1446, Nov 7). (Please scan the QR code below for a refresher.) Eventually, the Fed will cut rates, perhaps in 2024. Markets will anticipate this and falling yields will boost bond prices.

Aside from Treasuries, we also bought Singapore and Japanese bonds for the Global Portfolio, on expectations that the greenback will weaken as the US rate hike cycle nears its peak. This has also proven to be true — the US dollar has given up part of its year-to-date gains in recent weeks, including against the Singapore dollar and the yen.

Global slowdown will hurt Malaysia’s export prospects

The global economic slowdown will hurt Malaysia’s growth in 2023, given our country’s heavy reliance on exports, and in particular, the electrical and electronics (E&E) sector. For the near-medium term, sales will be affected by falling end-demand for goods as well as unwinding of stockpiles by businesses throughout the supply chain. The S&P Global Malaysia Manufacturing Purchasing Managers Index (PMI) is in contraction territory at 47.9 points in November, worsening from 48.7 in October as new orders slow (see Chart 4).

Consumer spending, we suspect, will also start to decline next year as inflation bites. Case in point, although retail trade continues to trend up, sales in terms of seasonally adjusted volume have already weakened since May (see Chart 5). There will be very limited aid from the government, given the country’s strained fiscal position, persistent budget deficit and inability to raise taxes. A goods and services tax (GST) is simply not politically palatable while reducing the overall subsidy bill with targeted subsidies is also complicated — and risky. For instance, any pullback in petrol and electricity subsidy will surely drive up costs and prices across the board, and further hurt the average consumer spending power. Our greatest fear is that Bank Negara Malaysia will be asked to monetise some of Malaysia’s growing debt requirements. That would, without a doubt, be disastrous for capital markets, investments and the ringgit.

Over the longer term, Malaysia’s heavy reliance on E&E and the weaponisation of chips too warrants greater caution. It is inevitable the world standard will bifurcate, Western and Chinese, leading to greater uncertainties, more onshoring of investments and production. Given that Malaysia’s E&E sits on the lower rungs of the value-added chain, we foresee drags on new investments that would eventually translate into lower production.

In short, we are very cautious on the outlook for Malaysian stocks for 2023 — and beyond — and this is reflected in the defensive composition of our portfolio. Aside from stocks with expected stable income streams, we think the oil and gas, and perhaps plantation, sectors could outperform next year.

We are staying invested. Holding cash for any extended period of time is a losing strategy as inflation will eat away at the purchasing power of money. The Malaysian Portfolio performance has proven to be resilient over the years, even when the broader market was falling. The compound annual growth rate (CAGR) for the portfolio stands at more than 11% since inception, way better than any bank savings return.

The Global Portfolio gained 1.3% for the week ended Dec 14. Chinese stocks continue to outperform, with Yihai International Holding (+9.7%), Alibaba Group Holding (+5.4%) and Li Ning Co (+3.1%) leading the gainers. On the other hand, Global X China Electric Vehicle and Battery ETF (-3.1%) and iShares 20+ Year Treasury Bond ETF (-1.2%) ended the week lower. Last week’s gains lifted total portfolio returns since inception to 28.8%, though we are still trailing the MSCI World Net Return Index’s 40% returns.

Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/ or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.

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