“Risky or Rally – Investors seeking direction as we move into the year-end”

Market Overview:

“Historically, the S&P 500 has garnered a positive return over the last three months of the year. Many investors are looking forward to a “year-end” rally which will take markets to new all-time highs. However, with various headwinds on the horizon, we urge investors to adopt a more conservative approach towards the year’s end.”

Figure 1: &P 500 Monthly Returns (Source: Investopedia)

Given the signals that the FED will announce its asset purchase tapering in November, we expect the markets to remain volatile, depending on the speed and magnitude of the taper. FED officials are now evenly split on whether to start hiking interest rates in 2022.

Across the Pacific, China is continuing to face uncertainties across its real estate market as more and more companies face defaults over its debt repayments – headlined by China Evergrande Group.

In recent times, leaders in China have been emphasising financial and social stability over sheer growth. They speak of the goals of “moderate prosperity” and “common prosperity”, and households accumulating more debt to buy multiple or more luxurious homes does not necessarily fit that vision. Nor does the wealth inequality that the property booms have created. Xi’s pledges to cut pollution and carbon emissions also require the curbing of construction.

Then, the question beckons – how to do so without crushing the domestic property market, crippling more developers and derailing the country’s economy?This is quickly turning into one of the biggest economic challenges Chinese leaders have faced in years, and one that could reverberate globally if mismanaged.

That being said, the situation remains very dynamic and fluid, investors should remain cautious and expect even more volatility towards the end of the year. We continue to recommend a more defensive and ultra-selective portfolio allocation, stock picking in certain sectors will be of utmost importance. Investors may also consider taking advantage of any volatility through the use of tactical trading strategies.

Fixed Income Overview:

Investors seem to be turning their attention to Treasury yields. We anticipate FED Funds rate to be kept 0% – 0.25%, with three to four rate hikes by the end of 2023 based on the September 22nd meeting. The 10-yr US Treasury rebounded to 1.61% as of 12 October 2021 from 1.48% as of 28 September 2021 and is expected to be around 1.0% to 2.0% for the year of 2021. However, we do foresee a likelihood for Treasury yields to increase further towards to the end of this year, depending on the economic data and Fed’s policy stance.

The credit default swap (CDS)index for Asia ex-Japan Investment Grade entities rebounded to 98 as of 12 October 2021 from 88 as of 28 September 2021. Asia IG credit spread also increased to 132 as of 12 October 2021 from 124 as of 28 September 2021. We expect IG bonds credit spreads to range bound over the coming months. Asia HY credit spread rebounded sharply from 940 as of 28 September 2021 to 1051 as of 12 October 2021. We expect sentiment in the HY bond market to remain relatively weak as there continues to be adverse news emerging out of the Chinese market.

Figure 2: CDS Asia ex-Japan Index 1-year Chart (Source: Bloomberg)

Highly leveraged HY bonds (B rated) may face refinancing/default risks – several onshore/offshore bonds have defaulted recently including bonds issued by Sichuan Languang Development, Sunshine 100 China Holdings, Fantasia Holdings. As the government support weaken, four Chinese AMCs (Huarong, Cinda, Orient & Great Wall) may be downgraded by respective credit rating agencies and their credit spreads may widen.

We caution investors holding marginal investment graded bonds (BBB-, Baa3) to be wary of downgrades. For investors with an investment grade bond portfolio mandate, we recommend bonds with BBB+ ratings or higher, and portfolio duration of 2.5 – 3 years.

We again recommend investors to stick to short dated high quality (BB Rated) High Yield bonds with a duration of less than 3 years and reduce/control their exposure to highly leveraged BB-rated bonds (Greenland, RiseSun) and all B-rated Chinese real estate bonds. Investors should be prepared to hold their bonds to maturity. Geographically, we are overweight Emerging Markets’ bonds (Investment Grade and High Yield with BB ratings excluding China) and neutral on Developed Markets’ and Chinese bonds.

Further, we recommend investors to match their exposure of high-beta bonds such as: CoCo Bonds, Perpetuals, and high yield bonds to their respective risk appetites. It is also recommended for investors to hold a more diversified fixed income portfolio or to reduce leverage of portfolios due to various uncertainties across sectors. We advise investors to dive deeper into the issuer’s stand-alone fundamentals to ensure the strength of the company.

We recommend investors to continue to monitor low beta bonds. For reference, the purchase yields for 3–5-year low beta IG bonds are at 1-2%, and 3-5-year low beta HY bonds are at 3-5%. Overall, we recommend a balanced and more diversified portfolio of high quality (BB rated) high yield bonds and short duration IG Bonds. Although the absolute returns in the fixed income market may be low, it is still advised to maintain a portion of the portfolio in fixed income given the heightened volatility of the markets.

Equities Overview:

The start of October also signals the start of “earnings season”, as investors keenly look forward to companies’ 3rd quarter results and their guidance for the year end. The upcoming earnings reports could either be a catalyst or a hindrance for the markets as we move into the year-end.

As global economies continue to adapt and reopen, many investors expect a strong rebound of both revenue and growth. However, prices of raw materials such as oil, aluminum, steel and coal continue to remain high and are likely to erode the bottom line for many of the listed companies – impacting the cost of goods and therefore affecting their net profit margins.

Therefore, given the backdrop of persistent supply chain issues and elevated commodities prices, there is a strong chance to believe that some earnings may not be as favorable as expected.

Figure 3: Year-to-date chart comparing Dow Jones Index and Hang Seng Index (Source: Bloomberg)

With the potentially unfavorable earnings season in the US and the upcoming tapering, we continue to shift our geographic positioning. Despite regulatory headwinds continuing to hover over the Greater Chinese markets, we think that the worse is likely to be already priced in, and now we see value starting to emerge in select sectors.

Geographically, we recommend being overweight Greater China vs the US. Still, investors should hold some cash as a buffer and be prepared for a mid-long term investment horizon. We urge investors to stay constructive and selective in terms of stock selection and weigh their risk-and-reward. Volatility will persist, and investors should lean towards a more conservative portfolio.

Our investment strategy stays largely intact. We are overweight “Growth” vs “Value” and prefer sectors such as cybersecurity, consumer discretionary, select technology and healthcare.

It is important that investors adopt a well-diversified and defensive portfolio, reduce any over-exposure towards equities and raise some cash. In short, investors should employ a more back-to-basics stock selection approach and continue to adhere to company fundamentals and strict risk management principles (stop-loss mechanisms and/or appropriate portfolio hedging) to mitigate risks from market swings and uncertainties.