Turning points in the final lap

Inflation remains too hot to handle. In September, US Treasury (UST) yields surged and the risk-off sentiment gathered momentum, as investors digested the latest hawkish hold from the US Federal Reserve (Fed). Even though the Fed left the fed funds rate unchanged at 5.25-5.50% last month, its higher-for-longer narrative left the door open for further rate hikes.

September’s US payrolls surprised the market with a gain of 336,000 jobs (vs the consensus of 170,000 jobs) fuelling concerns that the Fed may keep rates elevated, or even hike rates further to control inflation. Benchmark 10Y UST yields reached 4.88% last week, the highest levels since 2007. While our view is that the Fed’s tightening cycle is over, having increased its fed funds rate rapidly to 5.25-5.50%, the upcoming September consumer price index (CPI) data will be closely watched as a harbinger for the Fed’s potential rate hike in the November policy meeting. At Bank of Singapore, we expect UST yields to stay elevated over the near term until a growth slowdown becomes clearer. Hence, we raised our forecasts for the 10Y UST yield over the next 3-6 months but see it settling to 3.25% in 12 months as slower growth sets in.

Heading into the final quarter of the year, we maintain an overall defensive stance on risk assets, amidst the delicate balance between economic growth, interest rate volatility and valuations. The heightened geopolitical situation from the attacks by Gaza militants in Israel add to uncertainties in the Middle East, with negative repercussions on risk sentiment.
We see four pivotal turning points - across the global economy, geopolitics, technology and climate change - that will determine investor positioning and market conditions for this year and beyond.

Global Growth: A delicate balance

The global macro picture in 2023 has been more resilient than anticipated, but slowing growth momentum, sticky inflation and “higher for longer” interest rates point to an uncertain outlook for 2024.

The “goldilocks” scenario of a soft landing for growth and orderly disinflation towards the Fed’s inflation target has been challenged lately by a series of mixed data releases and geopolitical pressures. We cannot underestimate the growth drag as higher interest rates weigh on credit creation and corporate profitability. As the variable lag from tighter monetary policy works its way through the real economy, we could witness a volatile re-pricing of risk and near-term consolidation. The lagged effects of the strikes by US auto workers and risks of a government shutdown weigh on sentiment.

The recent oil price rises to almost USD100/bbl have also raised fears of stagflation, as higher energy prices fuel inflation amid a slower growth environment. This will complicate the central banks’ inflation fight and further raise market risks.

China’s “make or break” moment

China's policymakers have implemented a series of fiscal and monetary policies aimed at giving the economy a shot in the arm, as well as to lend support to the ailing real estate sector. Focus is shifting towards the efficacy of policy actions on the real economy. As sluggish China activity and widening unfavourable interest rate spreads remain a big hurdle for the CNY, we expect modest appreciation of the CNY within the next 12 months. We expect China’s growth momentum will start to improve while the US economy decelerates by early 2024.

Chinese equities will stay range-bound over the near term, due to the lagged effect of policy measures. Quality defensive companies in telecoms, energy, travel/tourism, as well as the internet and platform sectors are preferred. Fixed income investors can consider reducing exposure to China property on any bounce, as the long-term fundamentals of the property sector and the wider implications to the financial sector remain concerning.

Artificial intelligence (AI): Innovation booster

AI technology is transformative for many industries. As generative AI moves from training to inference hardware, we see a proliferation of AI applications that can drive productivity, enhance creative content production and radically transform customer experiences. However, the financial impact on corporate profitability from AI adoption will take time.

In technology, the reshoring theme is well-supported by government initiatives such as the IRA and CHIPS Act in the US. However, as we head into an election year amidst the ongoing US-China rivalry, Chinese companies exposed to the US may face significant risks, while smaller domestic tech and semiconductor firms with access to domestic suppliers may be policy beneficiaries. US tech companies selling into China could also face restrictions from regulators in both countries.

Climate change: Weathering the heat

This year’s El Nino effect presented a palpable threat of rising temperatures, as highlighted by the UN World Meteorological Organization (WMO). Even as policymakers drive legislation to reduce greenhouse gas emissions aligned with net zero commitments, the upcoming UN Climate Change Conference (COP 28) to be held next month in United Arab Emirates (UAE) aims to hasten the energy transition.

Extreme weather events pose significant risks to energy sectors and food security, as agriculture and food supply chains may be challenged by shortages and price hikes. On the other hand, companies involved in agricultural innovation, renewable energy, smart grid technology and electric vehicles (EVs) stand to benefit. In fixed income, the Indian renewable energy sector is favoured given increasing focus on ESG and stable fundamentals.

How should investors position portfolios this quarter?

For the fourth quarter, we tilt towards a defensive asset allocation strategy, combined with rigorous search for investments with resilient attributes. In equities and corporate credit, we favour companies with healthy cash flows, low debt-to-equity ratios, earnings visibility and dividend growers, particularly those in defensive sectors.

In equities, we favour Japan equities which are supported by corporate reform, government policies and increased investor attention. We maintain a Neutral position in US and Asia ex-Japan equities and Underweight European equities. Within fixed income, we continue to Overweight USTs and Developed Markets (DM) Investment Grade (IG) as hedges against a recession. For bond portfolios, we advocate a barbell strategy in terms of duration: front-end yields offer the highest buffer against rates movement, while the long end offers greater long-term price appreciation (albeit with higher volatility) for hold-to-maturity investors.

Investors could add ballast to portfolios via traditional safe-haven assets like gold and Japanese yen, as well as diversifiers like alternative investments. Unlike economically-sensitive industrial commodities, gold may benefit from a US slowdown while the JPY could strengthen in line with Bank of Japan’s policy normalisation.

Within diversified investment portfolios, alternative investments offer lower volatility and enhanced risk-reward. We see pockets of opportunity in private equity (as vintages in recession years can offer long-term returns), private credit and selected real estate / infrastructure opportunities backed by strong fundamentals. High-quality managers in multi-strategy and relative value hedge funds could also diversify portfolio risks.

We encourage investors to look through the volatility to position into well-diversified portfolios for the year ahead. Rather than shy away from risk altogether, core portfolios should be sufficiently buffered for potentially slower growth and higher volatility. For nimble investors, there are alpha opportunities where valuations are dislocated and could offer long-term returns.

This article was first published in The Business Times.