The confluence of risks alongside the reopening boost, China’s stimulus measures, and peaking inflation imply that a wide range of outcomes is possible. Bill Maldonado, Eastspring Investments’ Chief Investment Officer believes that investment playbooks need to challenge the status quo to help investors stay nimble and seize the opportunities that arise.
What is your outlook for the global economy and are central banks at risk of tightening into a recession?
Global growth conditions will continue to be challenged by a confluence of existing headwinds (e.g. Russia-Ukraine crisis, hawkish central banks, rising yields, supply shocks), in addition to China’s zero COVID policy. Fig. 1.
In the US, we believe that the consumer outlook is mixed as actual data indicate that consumer spending is seemingly resilient (e.g. pent-up demand, USD2.3 trillion of excess savings, decreasing household debt-to-disposable income), however, surveys are signalling a deteriorating outlook. We note that giant US retailers Target and Walmart recently missed their quarterly earnings estimates. Meanwhile, Europe is hit hardest by the supply disruptions stemming from the Russia-Ukraine crisis and as such faces a higher risk of stagflation in the near term.
We believe that developed market economies, largely the US, are still transitioning to a ‘late business cycle’, and thus it may be too early to call for a recession. The US Federal Reserve (“Fed”) is prioritising its fight against inflation over boosting near-term growth. There is a risk that it may hike rates into a growth restrictive territory and tip the US economy into a recession. The outlook for the emerging market (“EM”) economies is more mixed. While EM Asia anchors on China’s growth trajectory, other EMs face imported inflation, due to a stronger US dollar and supply disruptions.
On balance, economic reopenings post-COVID should be supportive of global growth, but tightening financial conditions alongside hawkish central banks, imply a wide range of outcomes. We are monitoring recession risks and will stay nimble to navigate the uncertainty and volatility.
How would the Asian economies fare against this backdrop?
With the decline in COVID restrictions globally, consumption is likely to continue to shift from goods to services. As such, Asian economies with large domestic populations are expected to fare quite well. The ASEAN economies should benefit from the reopening boost; this should be especially positive for Thailand whose economy is highly reliant on tourism. Commodity-based economies like Malaysia and Indonesia should also see good GDP growth in 2022.
At the same time, higher commodity prices from supply chain disruptions, rising energy prices and reopening pressures have lifted inflation across Asia. Asian central banks have largely been slower to hike rates relative to their developed market counterparts, although the pace appears to be picking up. That said, they may be less aggressive given that higher food and energy prices, which are key inflation drivers in the region, will impact disposable income. With Asian governments’ greater fiscal flexibility, they are more likely to rely on subsidies to mitigate food and energy inflation shocks.
Bonds and equities have both sold off in the first half of 2022. Does this weaken the case for a traditional 60/40 portfolio?
Historically, the correlation between bonds and equities is mostly negative (and hence provides the most diversification benefits) when valuations for both asset classes are not expensive. 2022 was unique in that both asset classes traded at relatively lofty valuations post-COVID, and we saw both asset classes experience large drawdowns recently.
Time horizon is an important aspect when considering the case for a traditional 60/40 portfolio. Strategic asset allocation has shown to be the most significant contributor in meeting a portfolio’s return objective over the longer term (five to ten years). Hence, the recent selloffs do not on its own weaken the case for a 60/40 portfolio. Valuations for both equities and bonds have improved dramatically since the start of the year. We think the potential peak in inflation this year implies that the 60/40 strategy could resume its strong performance over the coming decades. At the same time, tactical asset allocation from asset pairs and equity risk premia from factors (Value, Momentum, Quality etc) provide uncorrelated alpha streams which can help mitigate potential drawdowns. We believe broad diversification and liquidity are key considerations in slowing growth and a rising inflationary environment. Our multi-asset team has implemented a number of medium-term tactical asset allocation investment ideas which are expected to add value over a three-to-twelve-month time horizon. During times of high market volatility and high inflation, real assets, such as gold, are attractive havens. The team is constructive on US gold miners as a key source of diversification and inflation hedge. Historically gold miners tend to outperform US equities in a rate hike cycle. The team is also long global airlines as easing travel restrictions will see a steady recovery of the industry’s capacity and efficiency.
Can the year-to-date outperformance in value stocks continue?
The change in expectations around inflation and interest rates is refocusing the market’s attention towards profitability and free cashflows. This is likely to continue to favour value stocks. Decarbonisation will also require massive infrastructure and capital expenditure over the next decade, which should benefit value sectors such as industrials and materials.
Rate hikes are also bringing back a focus on valuations. Given investor exuberance over growth stocks in the past decade, the valuation dispersion between value and growth stocks in Asia remains large even though value has started to outperform since November 2020. This suggests that there can be further upside to value stocks in Asia.
The same thesis applies to the Global Emerging Markets and Japan where the valuation dispersion between growth and value stocks are still at extremes. Given the growth focus of many investors in the last decade, value stocks potentially offer alpha and diversification benefits to portfolios.
How can investors weather the more frequent equity market swings?
Low volatility equity strategies can help investors ride through choppy markets. This is especially so for Asian equity markets which are historically more volatile than developed markets and take longer to recover from market drawdowns. Low volatility stocks fall less during market declines, minimising the risk that investors exit the market at the wrong time. A portfolio of low volatility stocks generally represents firms with sounder leverage levels and have more stable and proven business models. As these stocks fall less in a bearish market, they only need to rise by a smaller magnitude to recover. This effect, when compounded over time, can potentially lead to superior long-term returns for investors. Income from equities can also help add resilience to portfolios. Dividend paying companies are a buffer during volatile markets, providing a more consistent return of capital given their strong cash-flow generating ability. Dividend income is a long-term driver of Asia’s equity returns, accounting for 25% of total annual returns over the last 20 years1. In addition, Asia appears well suited for an income strategy as the number of stocks in Asia Pacific ex Japan that have dividend yields above 3% is almost twice that of Europe and more than three times that of the US2.A careful selection of good quality dividend paying stocks provides a stable income stream to investors.