“Developments are indicating progress towards a soft landing”

Macro

As we step into the new year, we present our take on the fourth quarter rally in 2023. The markets have signaled for more rate cuts than anticipated as shown by the 0.785 bps delta between median policy rate projections on the dot-plot and effective rate implied by the 2024 year-end Fed fund future prices. Against the backdrop of December’s strong job data, there are still reasons to suggest why the Fed may still consider a frontload rate cut in 2024 to achieve a “promised” soft landing.

Source: CME Group Inc, as of January 4, 2024

According to the think tank Employ America, there are three principles namely non-linear downside risks in unemployment, proportionality between interest rate hikes and cuts, and data-dependency with respect to abating price pressures, that could help guide the Fed with monetary policy normalisation.

Firstly, real Fed fund rates are currently relatively high at 2.9% compared to the last decade, signifying expensive money and in turn slowing down the economy. Historical trend also shows that increases in unemployment tend to be swift and unpredictable in the wake of a recession – and recognised as a lagging indicator. A frontload rate cut thus becomes a strategic move for the Fed to mitigate potential non-linear unemployment risk, especially when inflationary concerns are currently subdued.

Source: Bloomberg Finance L.P., as of January 4, 2024

Another key factor contributing to the market’s anticipation of a frontload rate cut is rooted in the Taylor Principle. This rule, acting as a benchmark for interest rates in response to inflation and economic growth, stipulates a proportional adjustment (e.g., 1% disinflation prompts a 1.5% rate cut). The principle serves as a guiding framework for the Fed to achieve stability in prices and maximise employment. Maintaining symmetry in the interest rate path, both upward and downward, is hence crucial for the Fed to uphold its credibility.

Source: Bloomberg Finance L.P., as of January 4, 2024

In the latter half of 2023, the Fed shifted towards a data-dependent approach to prevent a recurrence of the premature pivot to rate cuts witnessed in 1967. While avoiding abrupt policy changes is prudent, prolonged adherence to tight monetary policy can potentially constrain the supply side, leading to higher costs for innovation and unintended consequences for long-term inflation. Understanding these three principles is therefore paramount for navigating market responses to shifts in policy normalisation deltas moving forward.

Source: Bloomberg Finance L.P., as of January 4, 2024

Acknowledging the potential for an economy soft landing in our base case, we also recognise that this may not necessarily translate into a soft landing for earnings, and in our bear case, a hard landing becomes a plausible outcome.

We have observed a gradual decline in S&P 500 sales and earnings over recent quarters, which reflects an ongoing economic slowdown. Monitoring earnings surprises thus becomes essential for assessing future earnings resilience. Interestingly, the last quarter witnessed many S&P 500 companies surpassing earnings expectations, contrary to bearish analyst predictions.

Source: Bloomberg Finance L.P., as of January 4, 2024

We reiterate our preference for large-cap quality companies across sectors given their low leverage, stable earnings, and profitability to tide through an earnings recession. However, as cyclical sectors in S&P 500 have experienced double-digit earnings growth, we take comfort in the likelihood of a soft landing in 2024.

Source: Bloomberg Finance L.P., as of January 4, 2024

Fixed Income Macro

Turning into the new year, developments are indicating progress towards a soft landing. 3Q US economic growth was a solid 5.2% annualized rate despite real consumer spending at 3.6% annualized vs estimates of 4%. 4Q growth is expected to slow relative to the strong 3Q but remain well within expansion territory. While global core inflation has stabilized above 3% annualized rate in recent months with downward pressure on goods prices contrasting with sticky service price gains, US November PCE moderated to below a 2% annualized rate. Accordingly, this outcome ratifies the notion the Fed hiking cycle is over and boosts confidence that the Fed can lower rates in 2024, particularly given a further expected moderation in inflation. The 2024 dot plot now projects 75 bp of rate cuts, the 2025 dots show 100 bp of cuts, and the distribution shows most FOMC members expect at least 50 bp of cuts in 2024. While FOMC members signal that policy should remain at a restrictive level for some time until inflation is sustainably lower, markets are pricing the first rate cut to occur in March and circa total 150 bp of cuts this year.

Markets’ Cut Pricing Deepens as Fed Positions for Pivot

Source: Bloomberg Finance L.P.

For credit, yields at multi-decade highs lead to buying of high grade and constrain corporate issuance. For the majority of both investors and borrowers, it is yield levels that matter first and spreads second. The current elevated yields should lead to ongoing institutional buying, stronger retail buying as stable/declining yields lead to strong total return and a pickup in foreign buying as USD-hedged yields improve. With the Fed funds rate having peaked and the US economy likely to experience a soft landing, macro conditions are supportive of rangebound spreads. The Bloomberg Asia USD Credit spread is currently 97 bp tighter than 12 months earlier. From a technicals perspective, although spreads are tight, a year of low issuance in 2023 and expected marginal supply increase in 2024 can allow high grade spreads to remain tight. Moderately wider high yield spreads are expected as an additional premium will need to be built into valuations as higher financing costs bite, growth slows, and the economic cycle matures.

In China, while the government is unlikely to introduce massive policy stimulus, the pro-growth policy stance will continue during 2024, with strengthened coordination between fiscal and monetary policies. In the absence of a housing market recovery near term, policymakers are stepping up efforts to mitigate risks arising from local government hidden debt. The total of central and local government debts, including local government hidden debt, is estimated to have reached circa 100% of GDP. The local government hidden debt issue does appear to being managed through debt swaps and restructurings and the PBOC providing emergency liquidity support to local governments if necessary, so that is less of a systemic risk in the near term. On the monetary policy front, the 7-day reverse repo rate has fallen to a historical low at 1.8% as the PBOC continues to guide lower the funding costs for the economy, to prevent spillover of property sector risks. As the impact of these stabilization measures are reflected in the coming months, the economy likely maintains its recovery momentum in 1Q24.

Fixed Income Strategies

Over the past weeks, global yields have continued the decline that began in October. With roughly 150bp of Fed easing priced by December 2024 (and nearly 70bp of cuts to the Fed funds rate by end 2Q24), markets are approaching the limits of what can be priced without emerging odds of a recession in the near term. Notwithstanding the progress on inflation normalization, easing to adjust for a ‘passive rise’ in real rates resulting from cooling inflation, will probably loosen financial conditions considerably. If the Fed were to follow through on the cuts currently priced, the risks of growth would shift to the upside. Such growth reacceleration, in the context of low unemployment, raises the odds that the Fed may not follow through with some of the later cuts being priced. Additionally, if the soft patch of 4Q23 growth data proves temporary, it suggests that another driver of the recent move lower in yields may be running its course. We are inclined to trim duration of bond portfolios.

The role of China state owned enterprises (SOEs) is evolving with the focus shifting to policy themes such as technological advancement, high-end manufacturing, and sustainable development. While this entails more capital expenditure in the focus areas, SOEs’ credit profile should remain intact given continued policy and funding support. For SOEs involved, margin expansion over the longer run should be credit positive. Most SOEs still have borrowing capacity and are the main beneficiaries of lower onshore rates. For their offshore debt, SOE issuers will continue to look for alternative funding channels rather than locking in higher rates in the offshore bond market. This should feed back into strong technicals, driven by limited supply and gradually shrinking bond stock. Position in commodity-related SOEs as the government diversifies supply chains and builds a strategic stockpile. We favour to continue underweighting the LGFV sector, which still faces strong headwinds due to limited revenue generation and high debt leverage.

China New Loans Growth Reflects Industrial Upgrading Focus

Source: Bloomberg Finance L.P.

In the India renewables sector, the government has set a target of adding 50GW of renewable energy capacity annually for the next 5 years, vs the country’s existing 180GW of renewable energy (including large hydro) capacity installed, with about 90GW under construction. To support growth of this sector, the government has introduced various supportive measures, including the Late Payment Surcharge (LPS) policy. The LPS aims to reduce rising receivables at Indian power generating companies (including renewable power producers) from state owned distribution companies (discoms). Discoms could be barred from the short term power exchange market if they do not meet their current obligations on time. These measures have had a significant impact on the overall receivables situation. From June 2022 to Nov 2023, total outstanding dues of discoms to power generating companies are -42% to ~INR 700bn (~$8.3bn). This has in turn improved cashflows across the renewable energy companies. Although leverage is unlikely to improve given that capex will remain elevated in line with growth of the sector, issuers are expected to have cheaper funding access via onshore banks and NBFCs. We are inclined to increase positioning in India renewables.