Principal Monthly Viewpoints (August 2022)
Q: Principal Asset Management (Asia) Investment Management Team
A: Crystal Chan, Principal Asset Management (Asia) Head of Investment Specialist
Q: Will the global economy enter a recession?
A: The global economy is facing multiple uncertainties, with some interlocked primary risks stemming from the Russia-Ukraine conflict. Geopolitical tensions have worsened supply chain issues this year, resulting in higher food and energy prices which pushes up inflation and leaves global central banks with limited room to slow the pace of monetary tightening. If Russia suspends natural gas supplies to Europe, inflation may climb further. Eventually, the global economy may grow by roughly 3% this year, with a risk to the downside.
Among major economies, we are relatively pessimistic on the Eurozone. Apart from the risk of stagflation arising from the energy crisis due to its connection with Russia, many countries within the region are facing their own problems besides war, such as political instability in Italy. The series of factors may have a negative impact of over 1.5 percentage points on its economic growth, while the annual growth rate may slow to 2% or lower. Our base case is that the region’s economy will enter a recession by the end of the year.
With inflation soaring to unprecedented levels, the ECB is left with no choice but to hike rate more aggressively. Not only was this the Bank’s first increase in over 11 years, but it was also only the third instance in history when the ECB hiked rates by over 25 bps, officially bringing the negative interest rate cycle to an end. Interest rates should normalise further at future policy meetings in the face of high inflation. However, policy tightening by the ECB may have limited effects compared with the US. Since surging energy and food prices in the Eurozone are a result of the Russia-Ukraine conflict rather than the economy overheating, there remains a considerable gap between overall inflation (8.6%) and core inflation (3.7%). Meanwhile, against a weak economic backdrop, rate hikes by the Bank will only lead to a further drag on the economy.
Q: With US benchmark rate rising to 2.5%, will the Fed reverse course and start cutting rates as the risk of economic recession rises?
A: The current rate hike cycle marks the quickest series of increases by the Fed since the early 1980s. Two more reports on inflation and two on labour markets are due to be published before the next FOMC meeting in September, leaving the future path of monetary policy up in the air. If inflation remains elevated, another hike of even greater magnitude may be in the offing. Nonetheless, overall inflation could possibly retreat as oil and food prices have started receding in recent months. With inflation expectations relatively contained, the Fed may hike rates at a muted pace from September onwards, and the benchmark rate may rise to 3.5% by the end of the year.
Fears of an economic recession may intensify as we approach the end of the rate hike cycle. A series of data published in the second half of the year show that the risk of a recession in the US is rising. At one point, the 10-2 year Treasury yield curve, generally viewed as a leading indicator of a recession, was inverted with a spread of over 40 bps, the largest inversion in over two decades. As the effects of tighter monetary policy begin to be felt and the global economy experiences a substantial slowdown, the risk of an economic recession in the US will be much greater at the start of next year. Our base case is that the local economy will be in recession by the first half of the coming year. If the Fed is unable to rein in the pace of policy tightening, the country may slip into recession sooner.
If economic recession becomes a reality, the Fed may start to cut rates again in 2Q23. However, given the inflation trends and mild nature of the recession, the Fed may not be able to perform significant cuts of at least 500 bps, or bring down the benchmark rate to near zero levels as in previous recessions. As a result, the US economy may experience an extended recession which could last three to four quarters, and could trigger substantial price adjustments. For this reason, US inflation may return to level closer to the policy target before the end of next year.
Q: What would be the investment opportunities outside of stocks and bonds?
A: Global equities fell by over 20% in the first half of the year, while sovereign or investment grade bonds also recorded losses of around 14% as yields jumped. If we take into account the performance of a portfolio consisting of 60% equities and 40% bonds, the traditional golden ratio of the two asset classes, the YTD return (as of June) was roughly -18%. This was the second worse six-month return since 1976, even trailing the performance during the 2008 Global Financial Crisis.
We are relatively cautious on equities in the third quarter and the rest of the year. We also believe bond markets could remain turbulent in an environment of high inflation and sustained policy tightening by central banks worldwide. In terms of asset allocation, apart from fixed income and equity, investors can consider diversifying portfolios with alternative assets to reduce investment risks. In times of economic downturns and rising rates, the traditionally preferred ratio between stocks and bonds may not be ideal. Investors can instead build a portfolio consisting of 30% equities, 30% bonds and 40% alternative assets. Examples of alternative assets include commodities, REITs, infrastructure and preferred securities.
Infrastructure investment is a relatively large field encompassing water, electricity, natural gas and other utilities, oil and gas pipelines, toll roads, airports, communications infrastructure, data centres and towers, as well as green and new energy infrastructure, being increasingly viewed as a way of addressing climate change in recent years. The infrastructure sector tends to have lower valuations than broader markets and can mostly be categorised as value stocks. Their volatility is generally lower than the broad market, with a beta of only 0.6-0.8 over the past decade. Since infrastructure companies can pass on costs to consumers, and have relatively predictable cash flow, their revenue can rise steadily despite high inflation. In the last two decades when inflation was above the median, average return of infrastructure stocks was as high as 12.6%, compared to only 8.7% for global equities in the same period.
Preferred securities are investment tools with characteristics of both equity and debt. These assets are popular in the US and European markets, and are investment grade securities offering relatively higher yields. Over 70% of preferred securities are issued by financial institutions such as banks, insurance companies and brokers, with the rest being issued by other sectors such as utilities and real estate. Geographically speaking, nearly 90% of the issuers are from developed markets such as the US and Europe. Compared with traditional bonds, preferred securities are less sensitive to rate changes. Some even have a fixed to floating rate structure where coupons are linked with interest rates. In addition, preferred and capital securities provide competitive yields and have shorter durations. Therefore, they could be less affected in a rising rate environment.
(Written on 16th August 2022)
Crystal Chan
Head of Investment Specialist
Principal Asset Management (Asia)