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A sombre outlook for 2H2023

Goola Warden
Goola Warden • 10 min read
A sombre outlook for 2H2023
From left: The Edge Singapore’s executive editor Goola Warden with speakers Leonard Eng of TD Ameritrade, Chan of Charlie Chan Capital Partners and Vishnu Varathan of Mizuho Bank / Photo: Albert Chua
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The outlook for the second half of this year remains sombre, the three expert speakers at The Edge Singapore’s MidYear Investment Forum (MYIF) on May 27 concurred.

Even with the US debt ceiling issue removed, the US Federal Reserve’s accelerated pace of rate hikes is likely to cause a global economic slowdown in the second half at best, with equity markets marking time, they say.

The forum was sponsored by TD Ameritrade. The first speaker of the morning was Leonard Eng, trade desk manager at TD Ameritrade Singapore. His topic was “Taking stock of the interest rate cycle”.

Eng was followed by Vishnu Varathan, head of economics and strategy at Mizuho Bank, whose topic was “Will there be a recession?” Since the short answer was yes, Varathan widened his presentation to include why China is unlikely to be the white knight for the region, which has been borne out by the latest PMI data out of China.

The third speaker was Charlie Chan, CEO of Charlie Chan Capital Partners and a well-known activist investor in Singapore. His topic was “Are the market’s troubles over?” The short answer was no and he explained why.

A recession in the cards?

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First off, the US recession watch. The inverted yield curve is most likely to lead to a recession, says Varathan. An inverted yield curve is when yields on short-term US treasuries are higher than yields on long-term treasuries.

The most commonly used durations are the two-year and 10-year treasury yields. Based on data compiled by Varathan, since 1988, an inversion was always followed by a recession.

Two things matter with the inversion: First, how deep it is and how long the yield curve has stayed inverted. “Except for the 1980s when the inversion was much deeper at 75 basis points (bps), a 10 bps to 30 bps inversion represents recession. We are now at about 53 bps,” Varathan says.

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In terms of timing, the average inversion duration is between 40 weeks and 80 weeks, following which a recession sets in. “The current inversion is riding up against 46 weeks. That seems to suggest that late this year or early next year, there’ll be some kind of downturn,” Varathan calculates.

Will China ride to the rescue?

However, China is unlikely to save the world or Asia this time round. Varathan has been pretty cautious despite the optimism surrounding its reopening.

Says Varathan: “China is not going to rebound strongly because of their [lack of] stimulus. They’ve got self-inflicted structural and geo-economic headwinds. Retail sales have jumped up since China started reopening, holding up well below its usual averages. The other [negative metric] is industrial production that is faring worse than during Covid.”

The transformation of the Chinese economy to a consumption-led from an investment-led one has some way to go. Now though, it appears there is a lack of confidence in the economy since investment is faltering.

“That’s going to take away from demand especially when your property market is still in a very weakened state,” adds Varathan. Based on his economic modelling, China’s domestic manufacturing is underperforming too.

“Structural problems are going to hold back China’s growth which means China’s growth will struggle to rebound back to 6% or 7%. Leverage is already elevated so the authorities are very concerned about having too much debt in the system. That’s going to hold back growth. The less credit you have, the less growth you have,” Varathan reasons.

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In addition to a slow post-Covid start, there is a deficit of confidence among businesses. Property developers are still grappling with high debt levels despite a recently issued 16-point plan. Meanwhile, tech companies are quite concerned about being split up or being put under additional regulatory pressures.

Interestingly, the latest data released on May 31 by China’s official NBS (National Bureau of Statistics) purchasing managers’ index (PMI) as well as the non-manufacturing PMI have shown another month of contraction and growth slowdown in May. The headline PMI contracted further to a five-month low of 48.8 in May from 49.2 in April. Services activities (non-manufacturing PMI) also further cooled down to 54.5 in May from April’s 56.4, its second consecutive month of growth slowdown and at the softest pace since January this year.

Weaker manufacturing and service PMIs may allow The People’s Bank of China to accept a weaker yuan to help improve export numbers, analysts have suggested.

While the role of the renminbi is increasingly relevant in trading, it is unlikely to displace the US dollar as the main trading currency. China has a closed capital account and the renminbi is not freely available. In addition, China’s growth has decelerated sharply while high debt levels have regularly plagued provincial Local Government Financing Vehicles (LGFV).

Varathan calculates that de-dollarisation is an unlikely scenario. On a personal level, Varathan asks, “If you have the situation where you need to store your wealth, my question to you is, would you want to store it in US dollars? That’s not a pretty option but let’s compare it against the renminbi and the rouble. I’ll just leave you with that thought.”

Which companies to pick?

What should investors do? TD Ameritrade’s Eng says certain sectors that have performed well in past periods of rising interest rates and inflation include gold, consumer staples and agricultural commodities during the inflationary period of the 1970s.

On the other hand, in 2004 and 2017, utilities underperformed during rate hikes but outperformed during the six and 12-month periods after a tightening cycle. “This could be a bullish indicator if the Federal Reserve has hit the end of its current rate hiking cycle,” Eng says.

Among the strategies, astute investors could employ include investing in companies with pricing power. “For example, Procter & Gamble (P&G) has a portfolio of consumer staples brands that have pricing power. During the high-inflation period of the late 1970s, P&G was able to increase prices and maintain its profit margins,” Eng says. “P&G is a large company that can pass on costs to customers and they are not significantly impacted by volatility in the supply chain.”

Another strategy is to invest in companies that benefit from rising commodity prices. Mining and material companies listed on the New York Stock Exchange include Freeport-McMoRan (FCX) and BHP Group (BHP). “They could benefit from rising copper and iron ore prices,” Eng suggests.

Among stocks to avoid, in particular, in US equity markets, are those with high debt levels and those that are interest-rate sensitive such as real estate and REITs. Most REITs can offer higher yields because of the debt they use to finance their properties and this is a problem as interest rates rise.

“Financial companies like banks may also be hurt by rising rates as they often have longterm assets (like mortgages) financed with short-term debt,” Eng says. In the US, banks such as Silicon Valley Bank (SVB) and Signature Bank needed to be “rescued” because of asset-liability mismatch.

“We know from the recent SVB and the First Republic Bank incidents that their funds are all tied up with securities that they cannot realise or if they are realised, is going to be very painful,” Eng says.

Caution as QT continues unabated

Activist investor Chan looks at most investment decisions through the lens of interest rates as they impact metrics such as weighted average cost of capital that in turn affects equity market pricing.

“I’m not as pessimistic as Vishnu but the reality has to set in — that interest rates in Singapore have gone from 1.5% to 4.5% in 15 months,” Chan says. Rising interest expense has caused everything else to go up, he reasons. This includes mortgage rates that will seep through the economy in higher prices.

The other part of rising interest rates is their impact on liquidity. In the past 10 years, the US printed trillions with quantitative easing, along with the European Union and Japan. That has caused inflation. Now governments are imposing quantitative tightening (QT) to drain liquidity from the system to control inflation.

As QT goes through the system, credit growth will be curtailed. “The balance sheets of banks may feel some stress and lending standards will have to be tightened,” Chan observes.

The other impact of fighting inflation is the strength of the Singapore dollar. “MAS is probably tightening by 2% against the basket. If you have foreign currency investments, you need to be very careful as you lose 2% against a foreign currency,” Chan cautions.

On a more upbeat note, Chan indicates that in his conversations with CEOs and CFOs, they expect interest rates to plateau and come down by as early as the end of the year. His view is that rates will stay high for at least six more months.

Be wary of REITs

A strong Singapore dollar coupled with Singapore’s transparent property market makes the city-state an ideal place to park money. Supply is well controlled by JTC for industrial land and property, and URA for commercial property. Hence, the local market is very well-calibrated. “You won’t have the boom-bust cycles you see in the US. In Singapore, buildings in the CBD are 90% occupied,” Chan says.

There are still risks. When borrowing costs were 1%, REIT managers could buy anything, make mistakes and nobody would lose serious money. “But when rates are at 4%–4.5%, a REIT would not be able to buy [the likes of Marina One] because its property yields are probably 3.5%,” says Chan. Furthermore, investors should also factor in management fees of 0.5%, he adds.

As such, investor education needs to highlight risks as well as opportunities. “When somebody buys new buildings at 7%–8% but it’s only for 22 years, the portfolio manager has to set aside capital for either land lease renewal. No doubt the yield is 8% upfront, but the value of the building could drop very quickly such that over the next 20 years, it becomes zero,” Chan says.

A major risk when investing in foreign assets is the impact of exchange rates, in particular on net asset values. For instance, Indonesian assets need to provide a yield of 5% higher than the equivalent property yield in Singapore, “or else it will end in tears”, Chan warns.

“A lot of fund managers are saying we should invest in Japan where you can borrow money at 0.8%. But look at the volatility of someone who invested a year ago in Japan and has lost 10% of his money,” Chan cautions, referring to asset managers who acquired Japanese assets a year ago.

Sectors such as travel and tourism have a brighter outlook. Singapore Airlines (SIA) is probably the best proxy to a rebound in travel and tourism. In Chan’s view, SIA managed to get on the front foot a lot earlier than the likes of Qantas or other regional carriers. Temasek provided SIA with a lifeline as did shareholders who subscribed to its rights issue.

“SIA survived and was the first to get off the ground. Right now, the company is running at 80% of pre-Covid levels, [with journeys] at higher prices,” Chan says. Even then, staffing is a challenge. The whole industry is very short of workers and SIA being the first to get off the ground will have huge pricing power,” Chan says.

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