Principal Monthly Viewpoints (November 2021)
Q: Principal Asset Management (Asia) Investment Management Team
A: Crystal Chan, Principal Asset Management (Asia) Senior Investment Specialist
Q:With the Fed cutting back on bond purchases in November, how will investment allocations in the fourth quarter be affected?
A:The Fed confirmed it will begin tapering from November onwards, in line with our earlier expectations. Over the past two months, the US labor market has remained tight as employers faced continuously rising recruitment costs. Meanwhile, inflation was high, with core personal consumption expenditure index (PCE) recording YoY growth of 3.6% in September, supporting the decision to reduce bond purchases. In the coming two months, the scale of bond purchases will be slashed by USD 15 billion each month. The program will conclude around June next year if the rate of reduction persists, representing a swifter cutback than in 2013. The actual rate of reduction will of course depend on the status of the economy, but we believe the scale of reduction is very unlikely to be increased further, so as to avoid another taper tantrum.
In terms of inflation trends, the Fed in the latest FOMC statement said elevated inflation reflects “factors that are expected to be transitory”, as different from earlier statements when it attributed higher inflation to “largely reflecting transitory factors.” Regarding the definition of maximum employment, Chairman Powell did not provide a concrete target, but implied that some positions may be permanently lost after the pandemic, which means the Fed may lower the threshold of maximum employment. Despite lagging developments in the employment markets, market participants depicted this as the Fed’s intention to raise rates as soon as the bond purchase program is concluded, in response to the risk of rising inflation. After the release of the statement, the Fed funds futures indicated a 90% chance of rate hikes next July, pushing expectations further ahead. Most brokers expect the US to hike rates twice next year.
We think the overall economic and inflation trends in the US meet the conditions for a gradual tapering, while markets have long expected the bond purchase program to be scaled down in the fourth quarter. Therefore, the impact of tapering on the economy and asset price is believed to be very limited. In fact, after the Fed began tapering, most major asset classes recorded positive returns a year on. Global equities slipped for a short period of time but still managed to gain 5% a year later. US stocks performed even better, with one-year cumulative returns close to 14%, and three-year cumulative returns reaching 25%.
Our stance on rate hikes is more conservative than markets. As the bond purchase program may end by mid-2022, we tend to believe that the Fed will commence rate hikes by the end of next year if economic data remain strong, and raise rates three times in 2023 as well as 2024, though the Fed will proceed cautiously. Markets may undergo corrections in the lead-up and early stages of rate hikes. The future inflation trend of the US will therefore be a crucial factor, as greater expectation of rate increases by the Fed may trigger a pullback.
Oil price movements, tightness of US employment markets and whether consumption remains fervent may continue to prop inflation up in coming months, casting a shadow over economic growth. At the moment, inflation peaking in the fourth quarter is still our base scenario, but the overall figure will stay elevated until supply chain shortage issues are gradually resolved next year, which should bring the figure closer to the Fed’s 2% target by the second half.
With central banks from various mature markets in different stages of tapering, the Global Financial Conditions Index, which reflects factors such as rates, monetary growth, spreads, market momentum and volatility, declined from 0.7 at the start of the year to 0.47 by the end of October. Data from the past two months reflected tightening financial conditions across major regions, but the index stays accommodative overall. It is however worth noting that the Fed’s balance sheet is currently over USD 8.5 trillion, more than doubled the size it was at the end of 2013, the last time when bond purchases were scaled down. We expect the balance sheets of G4 regions (US, Eurozone, UK and Japan) to remain expansionary overall in 2022, with market liquidity remaining relatively abundant.
Despite monetary policy being less accommodative overall, positive global economic trends, lower severity of the pandemic and faster vaccination rollout, coupled with optimistic fundamentals, especially leaded by the growth of corporate earnings, should allow equities to outperform other asset classes. We are slightly constructive on stocks in the fourth quarter, particularly those from mature markets.
Q:How will the outlook of HK stocks be affected by market concerns over the Chinese real estate debt crisis?
A: The real estate debt crisis continues to escalate. After Evergrande, Fantasia Holdings and Modern Land, it has been reported that Kaisa Group is also facing debt issues, reigniting investor concern that other leading real estate enterprises will be affected by that, dragging down Hong Kong real estate stocks. Chinese real estate equities in the Hang Seng Index fell close to 14% YTD, underperforming the overall markets. PE ratio of some affected real estate companies dropped to historical lows.
Despite lower valuations, short-term risks are yet to be fully alleviated, and markets should not underestimate the Central Government’s determination to regulate real estate markets. China has taken action to intervene in tech, education and real estate sectors this year, for preventing disorder expansion of capital while also taking common prosperity into consideration. China may take advantage of a period of lower pressure on economic growth to solve the issue of high property prices for the expanding middle class. Monetary and fiscal policy may be progressively and moderately relaxed to hedge the effects of the real estate market on the economy and finance. Since the Central Government has become more tolerant of slower real estate markets, more developers may face the risk of default in the future.
As real estate contributes a considerable proportion of China’s GDP, regulatory policies may increase the short-term downward pressure on the country’s economy. However, in the mid-to-long run, the industry’s debt crisis is not likely to trigger systemic financial risk. Under the supervision of the China Banking and Insurance Regulatory Commission (CBIRC) in recent years, the proportion of bank loans involved in real estate developers and mortgage is only 28%. In addition, with the “three red lines” limiting developers’ access to financing, developer loans with truly high-risk account for only 0.6% of total bank loans in China.
From an investment standpoint, although valuations of the Mainland real estate sector are relatively low, investors are still reluctant to purchase bonds issued by lower-rated developers, which may trigger more defaults in the future. Whether the industry can recover will hinge on developers with higher leverage overcoming refinancing risks and repaying their debt, whether requirements of collateral and bank loan issuance policies will loosen up, companies’ ability to issue overseas bonds to repay debt, and whether market confidence can be rebuilt to attract capital again.
Looking at Hong Kong stocks, given greater downward pressure on the Chinese economy, fiscal and monetary policy may remain accommodative, coupled with relatively reasonable valuations, the local market may perform better than in the third quarter. In terms of capital flows, the Southbound Trading received an inflow again in the last two months, but the size of HKD 9.8 billion in October was lower than September. As for fundamentals, P/E ratios of Hong Kong stocks are in line with the ten-year average while valuations are lower than global equities, but the weak earnings outlook of local companies may impede market performance. More importantly, it is still difficult to predict the precise turning point in Mainland regulatory policy. While investor sentiment remains relatively weak, the stock market may continue to experience volatility. After returning to 24,000 points in the fourth quarter, the Hang Seng Index had rose above 26,000 points at one point, but pulled back soon after. With the index unable to stay above the peak of the rising tunnel, technical trends remain relatively weak, we continue to be slightly pessimistic overall.
Q: What are the expectations on the trend of USD and RMB?
A: With the US is about to wind down its bond purchase program, inflation is still elevated and the economy is displaying robust growth, markets will gradually factor in expectations of a US rate hike next year, creating a tailwind for the dollar.
It is indeed possible for New Zealand, the UK, Canada and other mature markets to increase rates earlier than the US. Meanwhile, monetary policy in regions such as Europe and Japan are expected to stay accommodative, especially in Japan. It is worth noting that the EUR accounts for over 57% of the US Dollar Index, and up to around 70% when the JPY is included, which means these two currencies dictate the movement of the Dollar Index. With monetary policy differing across the board, against low-rate currencies such as the EUR and JPY, the USD may appreciate further.
Latest surveys show that with these supportive factors, fund managers’ optimism on the USD has risen to the highest level since 2016, while data from the US Commodity Futures Trading Commission (CFTC) reveal that long positions of leveraged funds are at a one-year high. In fact, the US Dollar Index has risen nearly 2% over the past quarter, and rose to 94.5 in the fourth quarter, its highest level in over a year, but has slid back to below 94 since. From a technical standpoint, if the Index breaks the 94.5 again this year, there will be a chance to challenge the 96 level.
Despite the USD’s strong movement, the China Offshore Spot to US Dollar (CNH/USD) exchange rate surpassed the 6.4 threshold again since the second quarter, and the China Foreign Exchange Trade System (CFETS) RMB Index, which reflects the exchange rate of the RMB against a basket of currencies, rose to a five-year high. The RMB’s recent strength may have to do with receding expectations of a broad-based RRR cut and higher actual rates, as well as improving relations between China and the US. Foreign capital flowing towards RMB assets may also have increased RMB demand.
However, with the Mainland economy slowing down and inflation under control, the PBOC will probably maintain accommodative monetary policies, as opposed to policy tightening by the US. It may be difficult for the CNH to break through the 6.3 level again by the end of the year. 10-year Treasury spread between China and the US has decreased from around 250 bps at the end of last year to around 140 bps recently, making the RMB relatively less attractive. USD/CNH will likely stay range bound between 6.3 and 6.5 before year end.
(Written on 10th November 2021)
Senior Investment Specialist
Principal Asset Management (Asia)