“Fed has removed the word “transitory” with regards to their inflation outlook. What’s next?”

Market Overview:

“The FED has removed the word “transitory” with regards to their inflation outlook. What’s next? Powell also indicated that they would end the tapering process earlier than expected.”

The FOMC committee decided to reduce the monthly pace of its net asset purchases by $20 billion for Treasury securities and $10 billion for agency mortgage-backed securities. Hence, the tapering process could end in March 2022 earlier than previously expected of Mid-2022. Additionally, the dot plot also signaled that there could be potentially 3 rate hikes each in 2022 and 2023.

While the market is grappling with inflationary pressures, faster than expected tapering process, Omicron added another layer of uncertainty leading to risk off sentiments with increased volatility lately seen via the U.S and Global indices. Countries, especially U.K and Europe, have started to tighten their covid measures into the year-end due to the spikes in omicron cases domestically, further dampening festive mood.

Going into the year end, with seasonality factor such as thinner liquidity in play, and various headwinds on the horizon such as supply chain bottlenecks, energy crunch, and inflationary pressures, we expect volatility to continue. Hence, we urge investors to adopt a more conservative approach towards the year end.

Figure 1: FOMC Dot Plot (Source: Bloomberg)

Figure 2: S&P 500 and Nasdaq indices (Source: Bloomberg)

Fixed Income Overview:

U.S Fed has indicated they will double the pace of tapering and the process could end in March 2022 earlier than previously expected of Mid-2022.

We anticipate FED Funds rate to be kept 0% – 0.25%, with three rate hike search in 2022 and 2023 (FOMC dots plot median at 1.6% by the end of 2023)based on the December 16th meeting. The 10-yr US Treasury dropped to 1.43% as of21 December 2021 from 1.44% as of 7 December 2021 and is expected to be around 1.25% to 2.25% for the year of 2022.

The credit default swap (CDS)index for Asia ex-Japan Investment Grade entities dropped to 84 as of 21 December 2021 from 93 as of 7 December 2021. Asia IG credit spread dropped to 123 as of 21 December 2021 from 131 as of 7 December 2021. We expect IG bonds credit spreads, except for Chinese issuers, to range bound over the coming months. Asia HY credit spread rebounded to 1204 as of 21 December 2021 from 1197 as of 7 December 2021.
We expect sentiment in the HY bond market to remain relatively muted to ranged spite the recent injection of capital of approximate USD 6.5 billion by various Chinese financial institutions to Huarong, aiding it to serve its debts and prevent a debt default.

Figure 3: 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, Sinic Holdings, Modern Land China, Evergrande. Evergrande also announced on 3 Dec 2021 that it planned to “actively engage” with offshore creditors on a restructuring plan.

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 recommend investors to stick to short dated high quality (BB Rated) High Yield bonds (ex-China)with a duration of less than 3 years and be prepared to hold the bonds to maturity. At the same time, reduce/control their exposure to highly leveraged BB-rated bonds (Greenland, RiseSun) and all B-rated Chinese real estate bonds. 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 and 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, with the expectation of rates going higher and more volatility going into year 2022, we recommend a balanced and more diversified portfolio, with short duration (less than 3 years) IG and high quality (BB rated) HY 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:

We reiterate our prudence strategy that continues to pay dividends as we saw markets pullback especially the Nasdaq index in past weeks (figure 2). With rising inflationary pressures, Fed to taper faster than expected, and Omicron adding uncertainty, we envision the continuation of higher volatility into year end. To add, with the Fed being more transparent and managing market’s expectation, we continue to be constructive for equities, while being prudent and selective at the same time.

As we head into the year end, with seasonality factors such as thinner liquidity, and various headwinds on the horizon such as supply chain bottlenecks, energy crunch, and inflationary pressures, we urge investors to adopt a more conservative approach towards the year end and stay in selective blue chips.

Figure 4: 1-Yearchart comparing Nasdaq Index and Hang Seng Index (Source: Bloomberg)

Geographically, we maintain our stance being constructive on HK/Greater China vs the US in terms of valuation. Still, investors should hold more cash (at least 1/3) or hedge their portfolio and embrace higher volatility. 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 in conservative stance. We prefer sectors such as cybersecurity, select technology, auto, green energy, healthcare, and financials ex-China.

It is important that investors adopt a well-diversified and defensive portfolio, stay in selective blue chips, reduce any over-exposure towards equities. . 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.