“Potentially the last hike of this cycle; a short and shallow US recession forecasted for later this year”

Macro

The Federal Reserve delivered potentially the last hike of this cycle, retaining the option to continue tightening in June if conditions warrant. Near term risks—fears about regional banks and an unresolved debt ceiling—could further deepen cut pricing, but actual economic data, which while indicative of a slowing economy, remain robust. Both ISM surveys surprised to the upside, with the underlying composition of the manufacturing index strong. Nonfarm payrolls surprised to the upside as well, with the unemployment rate declining to the lowest level since 1969. And finally, US April headline CPI and core CPI both increased 0.4% month-on-month, 4.9% and 5.5% respectively year-on-year, in line with consensus expectations, requiring additional evidence that inflation is on a sustained downward path.

US debt ceiling concerns are likely to drive market sentiment near term. Congress may ultimately resolve the issue by either increasing or suspending the debt limit before Treasury runs out of cash to repay principal, currently projected to be early June. Meanwhile, the debt ceiling negotiations may run down to the wire. The two parties remain far apart — Democrats have stated they will only pass a clean debt ceiling raise, whereas Republicans state they want debt ceiling legislation paired with significant spending cuts. A short-term solution to buy time until 3Q is possible, but any stop-gap measure may not receive sufficient votes. Yields on Treasury bills maturing June—July can continue to rise and long bond yields decline as debate intensifies over the coming weeks.

In China, April data suggests that recovery momentum could be waning. Manufacturing PMI fell notably by 2.7 ppt to 49.2, the lowest reading in four months, although service and construction PMIs indicated ongoing solid momentum. Consumer inflation fell to a two-year low of 0.1% year-on-year and producer prices fell 3.6% year-on-year, largely due to lower commodity costs. Separately, credit and new loans came in at RMB 1.22 trillion, well below expectations for RMB 2 trillion after strong growth in 1Q. Lower manufacturing PMI, very low inflation and weak credit growth in April are all consistent with slower sequential activity growth after the initial stage of reopening boost passed. Chinese banks may have room to lower lending rates going forward after some of them cut deposit rates recently. A potential Fed pause expands headroom for the PBOC to cut its policy rate during this quarter.

China Consumer and Producer Price Inflation Falls Further

Source: Bloomberg Finance L.P.

Fixed Income Strategy

Market pricing Fed rate cuts of ~75 bp by the end of 2023 appears premature but partly justified by debt ceiling risks. In the worst-case scenario, if the deadline is breached and Congress is unable to reach an agreement, a technical default would likely have severe economic ramifications. Analysis released by the Council of Economic Advisors estimates that in the case of a protracted default, the unemployment rate would rise 5 ppt and real GDP could fall by over 6 ppt. In that type of event, long dated Treasury bonds likely outperform. Barring actual occurrence of a negative shock, the push and pull of left tail fears and still healthy economic data is expected to leave bond yields trading in a broad range. Be inclined to fade moves to both extremes.

We maintain our preference for investment grade over high yield despite the meaningful decompression in spreads over the past weeks. This is based on the fundamentals and resilience of IG credits whereas most HY segments are relatively more vulnerable to tightening credit availability from lingering financial stability concerns, on top of debt ceiling noise. Within the Asia HY sector, headlines that KWG, a China developer, defaulted on both onshore and offshore bonds and property conglomerate Wanda in talks to extend principal repayments of onshore bank loans, underscores the failure so far of most privately-owned developers to benefit from China’s nascent housing recovery. Maintain positions in IG developers that so far have capitalized on the recovery. Despite the requirement to step up their presence in the sector, their credit profile and liquidity have remained intact.

We maintain ourposition in shorter maturity senior bonds of select European GSIBs and US money center banks. 1Q23 earnings showed reassuringly modest deposit outflows, while deposit costs rose only marginally, loan growth in-line with expectations and CET1 ratios remained healthy during the quarter, and NPLs were contained with adequate loan loss provisions. Within the bank AT1 bond space, position in near term callable dates and high reset spreads where the market is most supported and offer a bit more of a premium for lower liquidity, with preference for business models that are less reliant on investment banking activity.

Equities Strategies

As it is, the interest rate pause seems imminent, but the timing of the rate cut is still unclear. Our view is that rate cuts may occur late this year, if any, for the reason that inflation is still way above its target and that banking sector turmoil hasn’t really spread to other sectors. This is in contrast with the futures markets, where it is pricing in three rate cuts by January 2024. Amid this uncertainty as well as the looming recession, we prefer to position defensively. Thus, we continue to be advocates of defensive sectors in US equities, ie. consumer staples and healthcare and concurrently seek opportunities to implement shorter-term tactical/swing trades through accumulating or buying quality, high beta US names such as blue-chip technology stocks as investors sector rotate into higher beta names in view of a potential end to rate hikes.

For HK/China, we continue to remain overweight in beneficiaries of the China reopening theme despite the slower-than-anticipated “reopening” thus far; Chinese airlines, domestic consumption-related, travel-related and F&B-related sectors. We are also skewed towards infrastructure-related names in view of an accommodative policy stance to support the domestic economy.

Research

The Conference Board Leading Economic Index (LEI) was down 4.5% over the 6-month period between September 2022 and March 2023. This was a steeper decline as compared to a 3.5% contraction over the previous period. The broadly negative performance of the index’s underlying leading indicators illuminates the worsening of economic conditions ahead, against the backdrop of the fastest rate hike cycle in the US history. Manufacturer’s new orders for consumer goods and materials, however, contributed positively to the LEI by 0.11% albeit a slowdown in pace for US manufacturing activity. We hold the view that US manufacturing activity will likely dampen in the near term as global demand softens which should reduce the dislocation between stock prices and current economic conditions.

The Conference Board Leading Economics Index and Component Contribution (Percentage)

Source: The Conference Board, data as of 20 April 2023

Most major financial institutions, including The Conference Board, are forecasting a short and shallow US recession to happen later this year. Bloomberg estimates a contraction in US GDP US by 0.6% and 0.2% in 3Q and 4Q respectively – further corroborating with the LEI results.

Source: Bloomberg, data as of 8 May 2023

Most major financial institutions, including The Conference Board, are forecasting a short and shallow US recession to happen later this year. Bloomberg estimates a contraction in US GDP US by 0.6% and 0.2% in 3Q and 4Q respectively – further corroborating with the LEI results.

Source: Bloomberg, data as of 8 May 2023

Historically speaking, the S&P 500 is likely to find a bottom during a recession. This is also typically preceded by a period of decline in price-to-earnings ratio as analysts readjust earnings estimates to reflect the macro environment. In the event of a recession later this year, we may expect US stock prices to decline further i.e., SPX Index is already down 13.2% from all-time-high levels since December 2021. Therefore, this highlights the need to adopt hedging strategies to minimise drawdown on a long-bias portfolio. For example, when an asset value decreases by 20%, an investor requires an asymmetrical and higher returns of 25% to offset losses.

We favour hedging strategies including staying in cash, diversification through asset allocation, options, and structured products. The choice of strategy would widely depend on the unique needs of each portfolio but would also differ in terms of the amount of downside protection and hedging costs.