Quarterly Asset Allocation - 4Q 2022
4Q Investment Outlook: short-term outlook for equities adjusted to slightly bearish
Q: Principal Asset Management (Asia) Investment Management Team
A: Crystal Chan, Head of Investment Specialist of Principal Asset Management (Asia)
Q: In the last quarter of 2022, what are the major risks facing the investment market?
A: The rest of the year is inseparable from the three major investment themes of continuously high inflation, tight monetary policy, and economic recession.
In the World Economic Outlook released in July, the IMF projected inflation in advanced economies to reach 6.6 percent this year. From the latest U.S. CPI report for August, inflationary pressures are still very high and fading slower than expected.
CPI has fallen over the past two months following the decline in fuel prices. However, supported by structural shortages and geopolitical shocks, the room for oil prices to go down significantly further may be limited. U.S. oil prices may hover below a hundred dollars before the end of the year, implying that the attribution to a further decline of CPI should be relatively small. In fact, the source of inflationary pressure has shifted to the demand side of the economy. The prices of consumer staples, for instance rents, are still rising, which could have a rather far-reaching effect. Therefore, we expect the headline CPI to only fall to about 7.5% by the end of the year.
Given high inflation, a still tight job market, and upside pressure on wages, the Fed may need to uphold its tightening policy stance in the short term. The remaining question is whether the Fed can gradually decelerate the pace of rate hikes during the quarter. We tentatively believe that the benchmark rate may rise to at least 4.5% by the end of the year and the current rate hike cycle has a chance to peak in the first quarter of next year. Interest rates may reach as high as 5%, but everything will depend on the trend of U.S. inflation and other economic data.
Approaching the peak of the rate hike cycle, fears of recession risks may rise significantly. The 10-year-to-two-year spread, seen as a recession-forward indicator, has inverted by nearly 50 basis points, the deepest inversion in more than two decades. As the tightening monetary policy takes effect and the interest rate soars, the risk of a recession in the U.S. may increase considerably in the first half of next year. If recession comes true, the Fed may reverse course to cut rates in the second half of next year.
Considering the current inflation trend and a relatively mild recession, the Fed may not be able to significantly cut interest rates by at least 500 basis points or lower the benchmark interest rate to a level close to zero, as in previous recession cycles. We believe this recession would be shallow but prolonged for 3 to 4 quarters. A recession could trigger material price corrections. However, price levels may not come close to the Fed's target in quite a while.
Q: How should equity assets be allocated in 4Q?
A: In the face of rising risks of a global recession, together with high inflation and a continuation of monetary tightening globally, financial conditions may remain tight in general, which is unfavourable to the performance of risk assets. Despite relatively reasonable equity valuations, further stock price corrections may be triggered. As such, we have downgraded equities to slightly bearish. The downside adjustment risk in corporate earnings would be the main reason for equity markets to suffer from deeper corrections.
Brief rebounds are possible during market retreats. Since the end of last year, there have been five uneven rallies in the current bear market. The most recent rally was from mid-June to mid-August, when the U.S. market rebounded by as much as 17%. On average, the market recorded about 9% gain in the past five rebounds, which we describe as a bear market rally. In fact, the several bear markets in the past three decades were all associated with recessions, with the greatest average correction reaching 50% compared to just 24% so far this year. Considering the risk factors ahead, the downtrend of equity markets may continue.
From a regional perspective, our views on Japan, the United States, China, Hong Kong, and Asia are neutral, and we remain slightly bearish on Europe.
U.S. core inflation has accelerated again. Before the mid-term elections, it is doubtful whether the Fed can slow down the pace of interest rate hikes. The Fed fund rate may reach as high as 4.5% by the end of the year. U.S. financial conditions have tightened to a large extent because of the rise in rates and the strength of the U.S. dollar, which is not a positive factor for the stock market. Even though its economy is relatively resilient compared to other developed markets, with high interest rates, the risk of an economic recession may increase significantly in the first half of 2023. Our view is neutral.
The Russia / Ukraine situation remains uncertain. Natural gas prices in Europe continue to rise, and European states are struggling to contain an energy crisis. As the winter begins, the issue may intensify. Inflation in the Eurozone is perhaps yet to peak. Even though the economy is relatively weak, the European Central Bank may need to raise rates to a large extent. Therefore, we are slightly bearish despite relatively attractive valuations.
Backed by relatively mild inflation, the Bank of Japan has been boosting the economy through aggressive monetary easing, supporting the equity market. However, due to the relative weakness in Yen, the central bank may intervene. Once local interest rates rise, it may dampen the economic recovery. We have downgraded Japan to neutral.
Outside of Japan, the Asian economy is relatively positive, and some ASEAN countries may continue to benefit from the reopening after the pandemic. Overall, despite the strong dollar, the decline of Asian currencies is relatively contained, and the risk of capital outflow may be controllable. However, external demand may be affected in the face of China and the global economic slowdown. Our view towards Asia is neutral.
China and Hong Kong
The Chinese economy has weakened again as the stimulus from the reopening of the economy has faded and there has been a resurgence in new COVID cases. Without a deepening of the industry regulations together with more supportive measures to stabilize growth, investors sentiment may gradually improve. In the fourth quarter, the market is watching the outcome of the 20th National Congress and whether the zero-COVID approach can be relaxed. We are neutral on China and Hong Kong equities.
Q: What about bond assets?
A: We remain neutral on fixed income overall. In the past month, global sovereign bond yields have soared again due to the rise of real interest rates, with the U.S. 10-year Treasury yield reaching as high as 3.5%. As downward pressure on the economy has intensified, the market may become more risk-averse and sovereign bond yields may experience a correction. We expect the U.S. sovereign yield to fall back to around 3% by the end of the year.
Global sovereign bonds may benefit from it and have been adjusted upwards to slightly bullish. Investment-grade bonds may benefit from a relatively reasonable valuation. Other than that, their total return may also benefit from a correction in interest rates. Our view is neutral. As economic conditions deteriorate, fundamentals will likely worsen, leaving more room for spreads to widen. High-yield bonds generally have a higher correlation to economic conditions and are therefore downgraded to slightly bearish.
Head of Investment Specialist
Principal Asset Management (Asia)