Daily Voice | Fed to keep rates on hold until recessionary signals emerge: DBS Bank's investment officer

Manufacturing and services PMI are both above 50 as at September, and inflation remains low and stable. From a monetary policy perspective, conditions are also loose and conducive for growth with the PBoC (People's Bank of China) cutting LPR (loan prime rate) since May (2023). However, for the Chinese economy to grow substantially from here, we believe policy stimulus, and in particular the successful implementation of it, is key.

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From an equities perspective, we believe that majority of the cautiousness has been priced in, though policy stimulus is still needed to turn sentiment around. This is especially true for the property sector and its debt woes, as this has a significant overhang on the financial sector as well as the overall equity market. On a broader level, we believe that an earnings recovery should take place in 2024 should the government follow through with the policy stimulus and measures start to take effect from next year onwards.

Are you in the camp that believes there is no possibility of a recession in the US now, considering several economic data points, including a resilient labour market and US earnings?

Since mid-2022 the street has been calling for the imminence of a US recession. More than a year has since passed and the much talked-about recession has yet to materialise. We attribute this to:

Resilient US corporate earnings, as corporates had seized the opportunity to lock in long-term financing at previously low rates, and have also taken advantage of rising inflation to mark-up their selling prices, and strong US domestic consumption given levels of excess savings by US households, low household debt, and low unemployment rates.

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Although the likelihood of a “soft landing” for the US economy is on the rise, it could be too early to conclude that the US economy is out of the woods. We note that interest rates have surged within a very short time, with the SOFR (secured overnight financing rate) interest rate benchmark surging from just 0.05 percent in February 2022 to more than 5 percent today. It could take the impact of higher rates some time to work their way through the economy, and aggregate macro data could overlook cracks beneath the surface.

Divergence along credit quality lines as elevated interest rates and slowing growth are felt most acutely by the weakest borrowers. Credit rating agencies are also forecasting a rise in defaults among weaker credits, and the NFIB Survey on Small Businesses notes that small US businesses are already facing the most challenging credit conditions since post-GFC (global financial crisis).

This points to a challenging landscape and underscores our emphasis on investing in quality companies. Using US equities as a proxy, quality since August, US quality stocks have outperformed the broader market, reinforcing the view that as the cost of capital rises, companies with strong fundamentals to withstand a challenging environment are preferred by portfolio allocators.

Likewise for bonds, we also maintain our preference for high investment grade credit given their stronger balance sheets to tide through an elevated-for-longer rates environment. We are cautions on high yield credit, which could see spreads widen as defaults are expected to pick up come 2024.

Do you still expect one more final rate hike from the US Federal Reserve before 2023 ends?

The median of FOMC members projections currently still indicates that FOMC members are planning on a final hike this year (2023). However, market futures pricing suggests that we may have already seen the Fed’s final hike this year, with only modest odds of one more hike this year before the anticipation of cuts in 2024. In our view, regardless of one final rate hike or not, the Fed will likely keep rates on hold (at elevated levels) in the forthcoming months until recessionary signals emerge.

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A pause in the hiking cycle has historically preceded rapid decline in cash deposit rates. This underlines the need for investors to put their excess cash to work in portfolios, employing our Barbell strategy with an emphasis on high quality companies across credit and stock markets, which would be best positioned to weather an environment of higher-for-longer rates.

In India, do you still anticipate inflation concerns for the rest of the calendar year?

CPI data prints are so far in line with the central bank’s proactive and cautious stance on policy, drawing a balance between easing near-term inflation but heightened global uncertainties. The impact from geopolitical tensions in the Middle East on oil prices bears watching as it is highly uncertain how long this conflict could last. Inflation concerns will likely persist for the rest of the calendar year.

What are your thoughts on oil reaching $95 a barrel in the recent past?

Oil price has been driven primarily by two factors of late: tight market fundamentals stemming from production cuts by OPEC+ and Saudi Arabia, and the on-going conflict.

Point (i) is self-explanatory and should keep supplies tight for the remainder of the year (OPEC+ and Saudi have committed to maintaining these cuts until year end).

On the conflict, we believe these price spikes are more short-term and sentiment-driven (rather than fundamentals-driven) as the parties involved are not major oil suppliers and oil trade routes remain unaffected. Should the conflict stay contained, we predict that brent crude prices will remain above $85 a barrel with periodic spikes. We believe that $100+ are unsustainable unless the conflict snowballs to a much bigger scale involving multiple parties.

Of imminent concern would be stricter US sanctions on Iranian oil exports should the latter get involved in the conflict. At this stage, it is difficult to predict how the conflict will develop, but safe to say volatility will reign supreme and further upside risks to oil price are definitely there.

Why do you have an overweight rating on technology and communication services?

We are overweight on these two sectors as they are beneficiaries of the global digital transformation trend; accordingly, growth prospects and opportunities remain robust vis-à-vis other sectors. This is especially true in the context of AI developments and monetisation opportunities that have taken place this year.

Furthermore, many companies in this space have undergone cost rationalisation for much of the year, improving their operating efficiency and providing room for earnings growth and margin expansion moving forward.

Nonetheless, we remain selective even in these sectors, with a bias towards quality companies and sector leaders for their superior growth prospects and resilience amid market volatility. In particular, we look for companies that have MOAT characteristics such as high switching costs and strong network effects as they help to provide pricing power and ensure that rising costs are passed on to the consumer.

Additionally we also look for companies with robust balance sheet and cash flow generation abilities as such financially strong companies will be better positioned for ‘higher for longer’ rates.

Do you anticipate significant growth in the financial sector?

Higher for longer rates should benefit banks and financial institutions in Q4CY23. That being said, we believe that there is limited runway for further rate hikes by the Fed, and therefore net interest margin (NIM) should peak and subsequently contract in future quarters. Beyond the rate hiking trajectory, the main factor that will determine how well the financial sector does is the overall macroeconomic climate; if economic activity continues to expand, loan growth and demand for financial services should remain resilient.

However, in the event of a recession, banks will suffer as demand for credit falls and delinquencies and losses from bad debt rises. Our base case is that of a soft landing/mild recession in US and Europe, which is neither excessively positive nor negative for the growth outlook of the financial sector.

Japan’s banks are benefitting from the gradual relaxation of the YCC (yield curve control) as well as a buoyant economy that is currently experiencing a reflationary period.

Despite a gradually recovering economy (GDP growth, manufacturing activity etc.) China banks are facing headwinds in the form of property sector woes, downward NIM pressure from rate cuts, and existing mortgage repricing and potential LGFV (local government financing vehicle) restructuring; growth will be dependent on how well government stimulus measures are implemented.

Are you making substantial investments in the healthcare sector?

We remain overweight on healthcare as we seek to ride on long-term secular trends such as ageing populations and rise in chronic lifestyle diseases. Other tailwinds for the sector include technological advancements, changes in healthcare policies, escalating costs, and increasing affluence.

Within the healthcare space, our preference lies with companies operating in the Pharmaceutical and MedTech equipment subsectors, with a specific focus on globally recognised healthcare firms possessing diversified product portfolios. These companies face fewer regulatory and pricing pressures and are less exposed to the risks associated with drug discoveries and the expiration of exclusivity periods.

What's your perspective on the spike in US 10-year Treasury yields?

The surge in long-dated US treasury yields over recent weeks has driven aggressive bear-steepening of the yield curve, as 10-year treasury yields surged to a post-GFC peak. Long-end yields have been pushed up by a deteriorating US fiscal picture, rising debt issuance, and investors demanding a higher term premium as compensation for holding long-term debt. Bear steepening off an inverted yield curve is rare, and each time it occurred historically, it preceded a recession.

While the past does not always predict the future, the emergence of this rare phenomenon, given the spike in 10-year treasury yields, suggests a recession is likely, necessitating an up-in-quality stance in credit.

The recent sell-down in long-dated treasuries has affirmed our strategy to avoid duration risk. We have been committed to avoiding duration risk, preferring the 3 to 5-year duration segment, as inflation uncertainty, the US’ unsustainably high level of indebtedness, and challenging supply-demand dynamics for longer-dated treasuries, have suggested that risks remain in the long end of the duration spectrum.

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