“Ultimately, we believe key inflation data are still driving overall market direction in the mid-term”

Macro

US banking stability concerns are shifting market attention to signs of economic weakness rather than strength, overshadowing global economic data largely indicating both a resilient growth outlook and stickier inflation. The global composite PMI increased by 2.4pt in February to 52.1; both the manufacturing component (+0.9pt to 50.0) and the services component (+2.6pt to 52.6) increased. In Europe, the latest core inflation print notably showed a reacceleration in services in February, with markets repricing the ECB’s terminal rate +50 bp on the month to 4%. US Fed Chair Powell’s testimony to Congress indicated openness to increase the pace of hikes. US non-farm payrolls data continued surprising to the upside, although average hourly earnings moderated to 0.2%. It is likely that systemic risk in the banking sector is contained, which eventually should translate to “high for longer” pricing with reduction in cuts being priced or cuts being pushed further out.

Attention Shifts To Financial Stability Risks

Source: Bloomberg Finance L.P.

Bond fund outflows in the past several weeks reversed partially the inflows of January. EM hard currency bond fund outflows in February and month to date combined were $3.4 bn, reducing year-to-date inflows to $5.3 bn. Despite the outflow, Asia credit spreads held in well through rates volatility, with spreads currently at 269 bp, +10 bp month to date and remaining well below the 12-month average of 332 bp. This likely reflects a combination of improving growth data and cautious investor positioning. Nevertheless, the tight level of spreads can do little to insulate total returns, which are +1.7% year to date.

In China, the National People’s Congress and Chinese People’s Political Consultative Conference commenced with the annual economic growth target set at “around 5%”, which is modest vs expectations and reduces the probability of additional macro stimulus. In relation to the property sector, Premier Li at the NPC cited preventing “unregulated” expansion in the property market to promote its stable development, and “effective risk prevention and mitigation” in leading high-quality developers. The remarks suggest that: policymakers will maintain heavy regulation over the sector; developers with better credit metrics will benefit relatively more from policy support; the operating environment for many smaller and lower credit quality developers is likely to remain challenging.

Fixed Income Strategy

Markets currently price a US Fed terminal rate at ~5.2% but without yet factoring risk that the rate may be kept there for an extended period to slow the economy and bring inflation near the 2% target. In the event financial contagion risks are addressed, the upcoming CPI data if strong could result in cycle extension, on top of potentially steeper hikes. In this scenario, rates volatility likely picks up and results in widening credit spreads. On a relative basis, Asia credit appears better placed from both global growth reaccelerating and China’s rebound taking hold. Retain lower duration positioning and increase allocations to higher quality Asia credit.

Maintain position in Macau gaming operators. Operators reported 4Q22 losses that widened both year-on-year and quarter-on-quarter basis, which was before lifting of the travel restrictions across mainland China and Macau in January 2023. Macau February 2023 gross gaming revenue reached $1.3 bn, 33% increase year-on-year, vs consensus estimates for +31% year-on-year. February GGR was 41% of pre-pandemic levels. The recent GGR data is indicative of pent-up demand which is expected to contribute faster credit metrics improvement and lifting of the negative credit rating outlooks.

Position in high quality China property developers. The modest NPC growth target of 5% for 2023, together with its goal of defusing risk among leading developers while preventing unregulated expansion of the sector, appears to exclude room for further stimulus to spur a property sales recovery. Although February 2023 contracted sales increased 14% year-on-year, the first gain in 19 months since August 2021, this was due to Lunar New Year base effects this year and the same period last year. Further, sales recovery was uneven and skewed towards stronger developers, particularly state-owned enterprises. Among weaker developers, lower land bank and saleable projects hamper rebound, making further debt restructurings likely.

Equities Strategies

The Equities market are pulling back on the back of fears of contagion risks from Silicon Valley Bank’s failure. Given the Fed provided a backstop through an emergency lending facility and assurance of fund access to avoid bank runs, we believe the impact of this event is thus far muted and may provide a buying opportunity on quality US securities. Ultimately, we believe key inflation data are still driving overall market direction in the mid-term. Depending on the key measures of inflation (PCE and employment data) declining to a reasonable level deemed acceptable to the US Fed, the overhang on Global Equities, in particular US and European Equities (due to the lack of positive catalysts and relatively higher valuations), may continue to weigh on overall market sentiment. We are more inclined to add exposure in HK/China and also the US (albeit lower down the order to HK/China) versus the other regions.

Therefore, we recommend to Overweight in defensive positions for US equities, e.g. consumer staples and healthcare. Look to Underweight in US consumer discretionary as the sector is most sensitive to further interest rate increases while consumer sentiment is not improving. Look to accumulate or buy quality US names on the recent dips but any buying should be gradual.

Take partial profit on Chinese telecommunications companies (as valuations run higher) and keep remaining balance for dividends and defensive play. Remain Overweight in Chinese airlines, domestic consumption-related, travel-related and F&B-related sectors, which shall continue to benefit from the earlier than expected China re-opening in the near- to mid-term.

Research

Silicon Valley Bank (SVB) was shut down by US regulators on 10 March, marking the largest US bank failure since the Global Financial Crisis in 2008 and the second largest in US history. The bank’s failure can be primarily attributed to a mismatch between the duration of high-quality assets and deposit liabilities. Between 4Q19 and 1Q22, there was a rapid increase in US bank deposits because of a low-interest rate environment. This was coupled with a weak loan demand as the Covid-19 pandemic heightened recessionary risks. Against the backdrop, US banks had to buy into long-dated government bonds at generational low yields or alternatively held deposits in cash. As interest rates rose to a historical high over the last year, bond prices fell which led to an uptick in unrealised losses for US banks’ hold-to-maturity (HTM) bond portfolios. The unrealised losses do not pose a systematic risk to the US financial system per se on the condition that government bonds are held to maturity. However, in the event of a bank run like in SVB’s case, the bank is forced to sell its HTM portfolios to raise cash. Markets are concerned with the likelihood that the materialised losses, otherwise known as mark-to-market, would therefore triggers a domino effect across the US financial system if left unaddressed.

Source: JP Morgan Asset Management (2022)

Over the last couple of years, the US bank tier 1 capital ratio as a percentage of risk-weighted assets has risen to a historical high of 13.6%. This is in addition to a significant increase in unrealised bank losses of approximately US$620m as reported by the FDIC. We advise caution against an exaggerated US tier 1 capital ratio as unrealised HTM bond portfolios are not accounted for. Consequently, there is greater importance for US banks to ensure that the duration profile of their HTM bond portfolios matches deposit liabilities. Smaller US regional banks will likely experience further drawdowns as customer deposits are less sticky compared to larger banks including JPMorgan Chase and Citigroup. Another consideration is that the Fed will more likely implement a 0.25bps rate hike instead of 0.50bps to minimise the bank run contagion. A pivot towards a dovish stance will provide tailwinds to fuel a technical rebound for growth stocks. We recommend taking profits in the short term.

Source: FDIC (2022)

Apart from the collapse of SVB, we have observed several bear market rallies since the beginning of 2022. There have been clear sector performance trends as seen in the MSCI US Sector and Industry Indices.

Source: Bloomberg, data as of 9 March 2023

Notably, the lagging sectors in 2022 have outperformed YTD in 2023 and vice versa. On a sector level, technology, consumer discretionary and communication services have outperformed in 1Q23 against the backdrop of Fed hike cut expectations in 4Q23. Conversely, defensive sectors such as healthcare, consumer staples, utilities and energy have underperformed in Q123 as markets increase their risk appetite within the equities space.

Source: Bloomberg, data as of 7 March 2023

The Bloomberg weighted average forecasts suggest that economists remain optimistic about a US soft landing in 2023 and a gradual GDP recovery by 1Q24. However, we note that 6 out of 9 major banks are calling for a recession by the end of this year. This can be attributed to the 7 out of 10 recession indicators that have already been triggered since 2022 which are accounted for in the banks’ recessionary risk models.

Source: Goldman Sachs Asset Management, 31 January 2023

In consideration of the US sector rotation trends and GDP forecasts, we believe that markets have taken a much longer forward view (typically 6-7 months) against the present performance of the economy. We hold the view that the current market YTD performance versus the economy cycle is aligned as seen in the pick-up in technology and cyclical sectors despite ongoing recessionary risks.

For investors looking to de-risk and take advantage of the equity rally since October last year, we recommend a Deccumulator strategy to realise profits on technology equities.