“Over-optimism on rate cuts demands careful consideration”

Macro

Today, we will be going through a scenario analysis for 2024 to kickstart the year. Our base case is a US soft landing but it is important to consider and analyse the various outcomes of each case. Giving probable case to both bull and bear scenarios will allow us plan effectively in portfolio optimization, and allow us to prepare for the worst.

In the middle, is our base case scenario. US is heading towards a soft-ish landing has been increasing likely as the US labour market normalizes while China is also launching multiple rounds of monetary and fiscal stimulus. These actions increase global supply more than demand adding to the deflationary thesis. We see a gradual slowdown in GDP growth, consumer spending and corporate earnings with disinflation continuing but at a slower rate. In this case, the economy gradually slows down and avoids a recession.

On the left is the bear case with a US hard landing which is a sharp and prolonged recession with significantly lower GDP, higher unemployment and lower consumer spending/ corporate earnings.

Our bull case represents a “Goldilocks” scenario where financial conditions continue to ease (through the FED’s rate cuts) and corporate earnings continue to remain resilient. This is unlikely in our opinion but will drive the markets onwards if it were to happen.

Starting off with the bear case scenario which may be caused by the escalation of conflicts globally. As we know, the Israel-Hamas and Ukraine-Russia conflicts remains unresolved and if it were to broaden across resources-producing states, this would likely spike global resource prices, driving inflation. Furthermore, tensions remain high within Asia and emerging nations, stifling global growth and confidence.

In tandem, the recent developments in the Suez canal has materially impacted freight service (it handle 12-15% of global trade and 25-30% of container traffic). Container shipments through the canal were down 82% from Dec-Jan. Spot container rates more than doubled, but are still about half of the peak hit during COVID-19.

Furthermore, market rally in recent months have been quite optimistic, but forward earnings remain muted and earnings surprises have also dipped. Compression of profit margins also shows slowing global demand which will result in a repricing of company valuations.

Labour markets continue to cool off with job openings showing a downward trend. Inflation has also dropped significantly from its peak of 9% in May-23. However, we are still some distance away from the FED’s long term target of 2%, and the last stretch may prove hardest to achieve as stickier components such as shelter and service wages will take longer to fall. Analysts consensus is that we will range between 2.4%-3.4% by the end of 2024.

Another crucial factor that the markets are anticipating is when the FED will start cutting rates. The probability of rate cuts is extremely high, however the debate is on the extent and timing. Currently, the FED’s dot plot has forecasted 3 rate cuts (total 75bps) in 2024, but the markets are looking at up to a 2% cut with 5-6 rate cuts being priced in. This “over-optimism” may require some caution for investors.

In our bull case where inflation moderates quicker than expected and the FED turns dovish beyond what the market priced in, US Equities tend to perform well. In 5 of the last 6 rate cut cycles, the major indexes returned on average between 20%-35%. Therefore, it is still important for appropriate allocation in the longer term, on the assumption that global growth continues.

The “Magnificent-7” are a group of seven mega-cap tech companies have been leading the charge for US indexes. In the past 12months, they have significant outperformed the other “493” stocks within the S&P500 Index and for good reason. Their earnings growth has continued to remain resilient, consistently beating expectations when others have struggled.

At this point, we believe that this continued growth trajectory is probable as they have a wider moat, better quality factors on multiple fronts from their growth rate to balance sheet health. With investors currently prioritizing quality above all else, it invites capital flow from both retail/institutional investors.

Fixed Income Strategies

Pushback from Fed speakers against an earlier start to easing has led markets to not only reduce pricing of a cut in March, but also reprice the terminal level of Fed funds following an easing cycle higher by about 25bp. The prospect of a Trump presidential election victory, likely accompanied by unified government, is expected to feature fiscal expansion. In the context of an economic backdrop that already features low levels of unemployment, trend growth and at- or above-target inflation, if such an expansion is not sufficiently offset by renewed Fed tightening, is seeing markets begin to demand higher inflation and real risk premium in bonds. On the Middle East front, shipping disruptions have caused a surge in global shipping costs, raising concerns about renewed inflationary pressures. To the extent the backup in US yields since December only prices partially the confluence of above scenarios, we look to maintain lowered duration of bond portfolios.

Market Pares Expectation of March Rate Cut

Source: Bloomberg Finance L.P.

Credit spreads are currently bumping along the near term and perhaps medium term tights. Beneath the surface, 10s30s corporate curves at 17 bp currently, flatter by 5 bp year-to-date from 22 bp at end-2023, are at close to 10 year tights. This can be attributed to scarce long end supply as issuers shy away from long end issuance to not lock-in higher coupons. Overall yields at circa 6% remain at sufficiently attractive levels to continue drawing in incremental cash but unlike 2H23 this cash is being met with the typical January supply bump and spread valuations are getting to levels that look increasingly risky from a longer term risk/reward perspective. That said, near term if issuers deliver strong earnings results and their ensuing issuance is well absorbed there is a catalyst for a significant part of the market to come in from its recent wides. We are inclined to sell into strength if this materializes.

Macau gross gaming revenue (GGR) continues recovering with 4Q23 mass GGR at MOP41.4b, +11.8% quarter-on-quarter and +421% year-on-year; VIP GGR at MOP12.7b for VIP, +7.9% quarter-on-quarter and +486% year-on-year. The first 3 weeks of January GGR is estimated at MOP 13 billion, translating to MOP 619 million per day, up from December’s MOP 599 million per day and mass market GGR is at 105%-110% of 2019 pre-COVID levels, vs 105% of pre-COVID levels in 4Q23. The solid momentum in Macau’s mass gaming market can support faster deleveraging for issuers, despite ongoing China macro headwinds and VIP volume likely lagging as operators are unlikely to significantly expand junket VIP operations amid tightened regulations. Macau gaming operators start reporting 4Q23 earnings in late January, and industry EBITDA is expected to grow quarter-on-quarter due to increased visitation numbers and greater availability of hotel rooms. Spreads of operators rated BB currently between 35th and 40th percentile since the post-2009 period offer reasonable risk-reward. Increase positioning in BB rated Macau gaming operators.