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TES’s MYIF: There will be a recession and the market’s troubles are not over

Goola Warden
Goola Warden • 13 min read
TES’s MYIF: There will be a recession and the market’s troubles are not over
Second from left, Leonard Eng, TD Ameritrade, Charlie Chan, Charlie Chan Capital Partners, Vishnu Varathan, Mizuho Bank
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On May 27, The Edge Singapore featured three experts in their field as speakers during The Edge Singapore’s (TES) Mid-Year Investment Forum (MYIF), sponsored by TD Ameritrade.

The first speaker of the morning was Leonard Eng, Trade Desk Manager, TD Ameritrade Singapore. His topic was “Taking stock of the interest rate cycle”. Eng was followed by Vishnu Varathan, head of economics and strategy, Mizuho Bank, whose topic was “Will there be a recession?” Since the short answer is yes, Varathan widened his presentation to include why China is likely to be no White Knight for our region, and that has been borne out by the latest PMI data out of China.

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

Yes to recession

First off, the US recession watch. We’ve had an inverted yield curve for quite some time. Varathan crystallised the inversion and the length of time. 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 2-year and 10-year treausury yields. Based on data compiled by Varathan, from 1988 to the current period, whenever there's been an inversion it's been followed on by a global recession.

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

See also: MSCI announces five deletions for Singapore including CDL

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.

China won’t be a white knight

On China, Varathan has been pretty cautious despite the optimism surrounding its reopening. “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 its well-below-its-usual averages. The other [negative metric] is industrial production which is faring worse than during Covid.”

See also: SGX total securities market turnover value down 15% y-o-y to $23.79 bil in March

The transformation of the Chinese economy to consumption-led, rather than investment-led 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,” Varathan indicates. In addition, based on his economic modelling, domestic manufacturing is underperforming.

“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.

In addition to a slow post-Covid start, there is a confidence-deficit 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 under additional regulatory pressures.

Interestingly, the latest data released on May 31 on the official NBS Manufacturing PMI as well as the Non-Manufacturing PMI have shown another month of contraction and growth slowdown in May. Headline manufacturing activities (PMI) contracted further to a five-month low at 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 its softest pace since January this year.

Weaker manufacturing and service PMIs may allow the PBOC to accept a weaker yuan to help improve export numbers, analysts have suggested.

BRICS currencies won’t cut it

While the role of the RMB is increasingly relevant in trading, it is unlikely to displace the US dollar as the main trading currency. Neither does Varathan believe that the BRICS currencies could displace the dollar.

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In recent months, the BRICS – short for Brazil, Russia, India, China and South Africa and an acronym dreamed up by Jim O’Neill (now Lord), of Goldman Sachs Asset Management – are touting the idea of a single currency among them. Their currencies all start with R – real, rouble, rupee, renmimbi, rand – but even among themselves, some of the BRICS secretly prefer holding dollars.

Who would want their currencies? China has a closed capital account and the RMB is not freely available; in addition, China’s growth has decelerated sharply, and Nomura recently highlighted ongoing debt issues with provincial Local Government Financing Vehicles (LGFV).

South Africa is grappling with economic challenges clouded by corruption including at Eskom (it can’t even keep its lights on); Russia is prosecuting an unprovoked war on a neighbour and is the subject of sanctions. Urals crude is priced at US$55 a barrel compared to North Sea Brent at around US$70 a barrel. Brazil has a plethora of challenges, but is better placed economically than Russia and South Africa. Only India escapes the challenges faced by the other BRICS.

As Bloomberg columnist Andy Mukherjee put it, “a decade after China eclipsed the US as the world’s largest goods-trading nation, US dollar dominance doesn’t appear to be fading. The much-awaited petroyuan has so far been just a myth, even though some dollar-starved importers like Pakistan are keen to pay for Russian crude in the Chinese currency.”

Mukherjee continues: “An even bigger moat may be the greenback's role in fundraising. It will take the People’s Republic a long time to match the depth, liquidity and openness of the dollar-denominated capital market in which firms and banks borrow and hedge their risks. A proposed common currency for the so-called BRICS grouping of Brazil, Russia, India, China and South Africa may flounder for the same reason.”

Varathan appears to agree, but with a lot more data points. He too 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 (not a pretty option)? But let’s compare it against the renmimbi and the rouble. I'll just leave you with that thought.”

Choose companies with pricing power

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 1970s inflationary period. 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 investing strategies astute investors could employ is to invest 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 NYSE 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 the US equity markets, are stocks with high debt levels and which are interest rate sensitive, such as real estate and REITs. Most REITs are able to 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 long-term 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 realise, it’s going to be very painful,” Eng says.

Eng also suggests that investors do their own research to identify companies with free cash flow, and metrics that gauge whether companies can manage their interest expense. Although inflation appears to be tapering, investors should still ensure that companies have sufficient free cash flow.

Caution in the markets as QT continues to impinge on liquidity

Chan looks at most investments through the lens of interest rates as interest rates impact metrics such as weighted average cost of capital which 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 and that will seep through the economy in higher prices.

“If the average person has a $1 million mortgage for his condominium, what that means is that on a 3-4% interest rate he has to pay his mortgage increases of $3,000-$4,000 a month. If you work that through the system, if you are a landlord you will try and recover that from your tenant so your tenant is also not going to have a good time either,” Chan describes.

The other part of rising interest rates is its 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. “Banks' balance sheets may feel some stress and lending standards will have to be tightened,” Chan observes.

The other impact with fighting inflation is the strength of the Singapore dollar. The Monetary Authority of Singapore uses an exchange rate policy to keep inflation in check, and ensure ample liquidity in the system, as Singapore does not set its policy rates independently. The MAS's exchange rate policy also impacts corporate profitability, in particular for companies with large overseas operations.

"It's more of a strengthening of the FX rate. A word of caution here: 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 own view is that rates will stay high for at least six more months.

Be careful when investing in REITs

REITs with US office assets listed on the SGX have taken a beating in the past 15 months. Their fundamentals are different from Singapore’s, Chan points out. Singapore is a very transparent market. Supply is well flagged 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.

Once again, he flags interest rates as the driving factor behind the S-REITs. When borrowing costs were 1%, REIT managers could buy anything, make mistakes, and nobody would lose serious money. How times have changed; the good buys of yesteryear have become the good-byes of 2023.

“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%,” Chan reasons. When office yields are 3.5%, 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.

Investors need to be aware that when REIT managers acquire an industrial property with a 20 year lease at a 7% or 8% yield, on borrowing costs of 4% to 5%, the REIT could recoup its investment over the period, but REIT unitholders are left with no residual value.

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.

Similarly, Japanese assets are popular because of the spread between borrowing costs and asset yield. The Bank of Japan - to date - has not raised rates in line with the Fed, the European Central Bank and the Reserve Bank of Australia. “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. Travel is likely to steadily improve. Inbound tourism in Singapore is still slow. Singapore's visitor arrivals averaged 1.7 million visitors every month pre-Covid. "We are now at just over a million," Chan points out, suggesting there is room for growth.

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