iFAST 2023 Market Outlook: Click here for a must-read guide before you start investing in 2023

1. A global recession will likely be unavoidable

2. Inflation and interest rates to stay higher for longer

3. Overweight fixed income relative to equities

4. Prefer investment grade over high yield and short duration over long duration

5. Value stocks to outperform growth

6. Developed markets are relatively more attractive than emerging markets

7. Taking a more cautious stance on China

8. Tactical ideas to consider for your supplementary portfolios

9. This decade should belong to India

10. Peak USD in 2023

1. A global recession will likely be unavoidable

• As we head towards the beginning of a new year, recession signals are flashing bright red. Between the inverted yield curve, elevated inflation, geopolitical risk, and central banks that will stop at nothing to curb inflation, the world is on the brink of a global recession.

• A resilient labour market leaves the Fed no choice but to continue tightening. The current rate tightening cycle is the most aggressive since 1988, increasing the risk of a recession (Table 1). In addition, because changes in monetary policy work with a lag, there is a risk that the Fed will overtighten and cause a recession. 

Table 1: The current rate tightening cycle has been the most aggressive of them all 

• Aside from the Fed, central banks across the world are all tightening in unison as inflation across many countries hits multi-decade highs (Figure 1). Monetary policy has never tilted so overwhelmingly towards rate rises in the past five decades. Synchronised tightening can be extremely hurtful to an already fragile economy, especially when consumers and businesses are already under immense pressure from higher inflation and borrowing costs. 

Figure 1: The simultaneous tightening of monetary policies around the world has been unprecedented

• Tighter monetary policy is starting to bite. Leading economic indicators are already pointing towards a slowdown. Purchasing managers’ indices (PMIs) across most major markets currently show a contraction, reflecting the headwinds faced by the global economy.

• Outside of the US, other major economies such as China and Europe are also not doing well, adding to the risk of a global recession.

• Europe continues to struggle with high levels of inflation, with consumer price growth still in the double digits as of November 2022. The ECB has since responded with multiple rate hikes, marking a shift away from the negative rates adopted over the last 10 years – a move that will likely weigh on growth. Europe is also in a precarious position, given their heavy reliance on Russia for energy. With the Nord Stream 1 pipeline to remain shut indefinitely and a full embargo on Russian oil to hit in December, an energy shortage looks increasingly likely. If this materialises, we expect massive production cuts to hit Europe’s manufacturing industry, which will inevitably result in lower economic growth.

• With the conclusion of the 20th National Congress of the Chinese Communist Party in October, signs that China is leaning towards a top-down state-controlled economy as against a free market economy have become more visible. Geopolitical tensions with the west are also escalating dangerously as the US goes head-to-head with China over issues such as trade and the sovereignty of Taiwan. Looking ahead, China’s economy faces stagnation as it becomes increasingly isolated, while domestic demand remains very weak amidst a property crisis and the government’s commitment to maintaining zero-Covid. 

• Looking ahead, we expect slowing economic growth to result in margin compression, which leads to lower, or worse, negative earnings growth – thus limiting the upside potential of equities. While a recession is unavoidable, it is unlikely to be as severe as the one experienced during the global financial crisis in 2008, with the balance sheets of households and businesses remaining strong.

(Related Article: A global recession is likely unavoidable in 2023. Here’s how you can prepare for it.)

2. Inflation and interest rates to stay higher for longer

• Low inflation is gone for good. We believe that inflation is in a structural shift and that the decades of low inflation are coming to an end. The world is moving into a new regime where structural forces will lead to a more persistent rise in inflation in the years ahead. The decade ahead will likely be characterised by shortages in commodity and labour markets.

• The structural under-investment in upstream oil and gas assets is setting the world up for an even tighter energy market in the years ahead. The green transition will also contribute to longer-term inflation, as it is likely to create a huge boom in demand for green metals, the supplies of which are inadequate to satisfy future needs. The impact of climate change will also continue to challenge agricultural yields, making it a long-term driver of food inflation.

• Shortages are now arguably the most acute in the labour market, where extremely high job vacancies underpin hefty wage increases (Figure 2). The demand for labour has a long way to fall before it matches supply. Not even a recession can bring down inflation. The global labour shortage could be exacerbated by demographic changes, including an ageing population and a broader decline in immigration. As companies’ labour costs rise, they will likely pass them on to consumers in the form of higher prices.

(Related Article: Low inflation is gone for good. Here’s how to position for a new era of higher inflation.)

Figure 2: With close to 1.7 jobs available per unemployed person, demand for labour in the US remains high

• While inflation will likely moderate if a recession occurs, it is unlikely to return to 2% levels in a short period. Based on historical data, inflation across advanced economies has taken an average of 10 years to return to 2% once it breaks above 5%. Inflation will likely take much longer than expected to moderate. Consequently, with the Fed unlikely to cut rates anytime soon, interest rates will also be higher for longer. Coupled with an impending global recession, the world could be headed for a stagflationary environment characterised by slow growth and persistently high inflation.

(Related Article: How long will it take for inflation to hit 2%? Hint: much longer than you think.)

3. Overweight fixed income relative to equities

Following the brutal sell-off in fixed income markets this year, we are starting to see attractive value emerging within the fixed income asset class. Besides, with earnings estimates still looking overly optimistic and the macroeconomic backdrop fraught with uncertainties, we believe adopting a more defensive positioning in our portfolios is warranted at this point. At the portfolio level, investors should overweight fixed income relative to equities.

• Widening credit spreads, combined with monetary tightening have pushed bond yields close to levels that were last seen during the global financial crisis. As of 1 Dec 2022, the yield-to-worst of the Bloomberg Barclays Global Aggregate Index is approximately 3.43%. The much higher-than-normal yields today create an opportunity for investors to receive higher total returns over time, even if near-term market volatility persists.

• On a relative basis, the valuations of fixed income have also turned much more attractive as compared to equities. The spread between earnings and bond yields has contracted substantially, and it is now at 2.93%, one of the lowest points on record and is also more than two standard deviations below the 10-year average (Figure 3).

Figure 3: Spread tightening suggests that bonds are relatively more attractive compared to equities

4. Prefer investment grade over high yield and short duration over long duration 

• Within fixed income, we prefer investment grade over high yield. Although high yield bonds offer attractive income, a more defensive positioning may be more important in a recessionary environment. Going into a recession, investment grade bonds tend to outperform their high yield counterparts as the latter is likely to experience greater credit spread widening as economic conditions deteriorate. 

• We have turned less positive on Asian high yield. While valuations are at historical lows, the underlying fundamentals have changed permanently. On the other hand, Asian investment grade (IG) bonds are starting to look compelling. Asian IG provides a decent yield pickup over their global peers as credit spreads have widened significantly since the start of the year while credit fundamentals remain sound. 

(Related Article: After yields have climbed to 6%, Asian investment grade bonds are starting to look compelling)

(Related Article: Downgrading Asian high yield: Why we aren’t taking this risky bet anymore)

• In terms of duration, our preference is for short duration bonds. Yields on short-term bonds have moved significantly higher as compared to long-term yields, implying that investors can receive alluring yields without having to take on greater duration risk (Figure 4). 

Figure 4: Yields of shorter-dated bonds look more attractive

Table 2: Recommended products for short duration bonds

 (Related Article: 3 recommended funds that can give you higher rates than fixed deposits)

5. Value stocks to outperform growth

• We expect value stocks to outperform growth stocks in 2023. Value stocks tend to do well during periods of high inflation and rising interest rates. In a rising rate environment, investors should look to reduce the equity duration of their portfolios by favouring stocks that derive their valuations more from current fundamentals (value stocks) rather than those whose values depend heavily on earnings in the distant future (growth stocks).

Figure 5: Value stocks tend to outperform growth stocks during periods of high inflation and rising interest rates

• The current macro backdrop remains supportive for value stocks but challenging for growth stocks. This will likely persist as both inflation and interest rates are expected to stay higher for longer. Furthermore, value stocks have been a lot more resilient relative to growth stocks, having experienced much smaller negative earnings revisions amid the economic downturn this year. 

• Last but not least, value stocks continue to trade at a wide discount to growth stocks, further increasing the relative attractiveness of value stocks. As of 1 Dec 2022, the MSCI AC World Value Index is trading at close to a 50% discount to its growth counterpart, below the historical average of 27% discount and more than two standard deviations below the historical mean. 

• While investors should adopt a value tilt in their portfolios, that does not mean they should stay away from growth stocks entirely, especially given the sharp sell-off in growth stocks this year. Tech stocks, which constitute a large part of the universe of growth stocks, will remain relevant in the long run. Investors who wish to retain some exposure to growth stocks should opt for high quality tech names with strong profitability and balance sheets.

(Related Article: Keep faith in value investing in these troubled times)

6. Developed markets are relatively more attractive than emerging markets

• Following our downgrade of Chinese equities, developed markets now look more attractive relative to emerging markets. Within developed markets, we prefer the US and Japan. Japan is our top pick because of its accommodative monetary policy, positive impact from the reopening of its borders, strong pricing power of its companies, and last but not least, attractive valuations, all of which favour an upward rerating for Japanese equities. 

Figure 6: Earnings forecast and price performance of the Nikkei 225 Index

Table 3: EPS and upside projection for the Nikkei 225 Index 

• Recommended products for Japan  

o JPMorgan Funds - Japan Equity A (dist) SGD

o iShares MSCI Japan ETF (NYSE:EWJ)

• Even though we expect the US to enter a recession in 2023, it is unlikely to be as severe as the one experienced during the global financial crisis in 2008. Not only is the balance sheet of households and businesses stronger today, but the financial system is also on a much stronger footing than before, thanks to the Basel 3 capital standards introduced after the global financial crisis. 

• Meanwhile, Europe will most certainly enter a recession in 2023 and is the least attractive market amongst developed markets. Not only is the European economy struggling with record-high inflation, but the European Central Bank is also rapidly raising rates, a move that will likely weigh on growth. The region is also at risk of an energy crisis given its heavy dependence on Russia for energy imports before the war. If this materialises, we expect massive production cuts to hit Europe’s manufacturing industry, which will inevitably result in lower economic growth.

7. Taking a more cautious stance on China

• Following the conclusion of the 20th National Congress of the Chinese Communist Party, signs that China is leaning towards a top-down state-controlled economy as against a free market economy are becoming more visible. With SOEs prioritised over private companies, the long-term profitability of the private sector is now at risk. 

• Domestic demand remains very weak amidst a property crisis and Covid-19 lockdowns. With China unlikely to budge from its zero-Covid policy, we expect both consumer and business confidence to remain weak for the foreseeable future.   

• Aside from its domestic troubles, geopolitical tensions with the West have also been escalating dangerously as the US seeks to contain China’s rise while the latter has vowed to push back against Western sanctions with greater assertiveness. The issue of Taiwan’s sovereignty also adds to the simmering tensions between both sides. This will usher in a dangerous new era of hostility and economic tit-for-tat between the US and China.

• This seismic geopolitical shift will also reshape global supply chains as rising tensions have stoked distrust that is changing views on China’s reliability as a trade partner and supplier, causing countries to reassess their economic dependence on China. Multinational companies – already hamstrung by strict zero-Covid measures – will likely accelerate their shift away from China. As China becomes increasingly isolated from the world, its economy faces stagnation.

• With China’s economy likely to enter a low-growth phase and the underlying fundamentals of Chinese companies deteriorating permanently, we believe that investing in China now comes with significantly higher risks. As such, we have factored in a higher country risk premium for Chinese equities, thus reducing the upside potential. 

• While China has loosened some restrictions associated with its zero-Covid policy and unveiled measures to ease the financial pressure on embattled property developers, we believe the recent market rally will not last. Following the relaxation of measures, there has been a surge in cases, forcing several cities into lockdowns. A large proportion of the economy remains subjected to lockdowns.

• China’s population is under-vaccinated. Its healthcare system is also not equipped to handle a surge in hospitalisations. Furthermore, China also needs to change their propaganda on Covid-19. For the past three years, the Chinese media has portrayed Covid-19 to be such a dangerous virus that the country needs to be locked down. There is a deep-rooted fear of Covid-19. Even in the absence of restrictions, people have voluntarily stayed at home. Even if China ends zero-Covid immediately, the positive economic effects would not be felt until 2024.

Figure 7: Earnings forecast and price performance of the MSCI China Index

Table 4: EPS and upside projection for the MSCI China Index 

(Related Article: Downgrading China: New economic regime and rising geopolitical tensions bode ill for China's future)

8. Tactical ideas to consider for your supplementary portfolios

• ASEAN equities: ASEAN is one of the regions that will benefit from the shift in supply chains away from China. Despite an economic slowdown, the region’s economic data has remained robust thus far, and we expect growth for the region to remain relatively resilient entering 2023, amidst the ongoing regional reopening and recovery. ASEAN inflation is also relatively milder than major markets, such as the US and Europe, thus we expect a less hawkish response from ASEAN central banks which should be less damaging to the region’s growth and equity performances.

(Related Article: ASEAN: Resilience in a sea of uncertainty)

• Commodity-linked equities: Given our expectation for commodity markets to experience continued supply tightness, we expect prices to remain higher for longer. Energy prices are expected to remain at elevated levels as demand remains constrained thanks to years of under-investment in the sector. Meanwhile, the mining sector will be supported by long-term structural trends such as the green transition. With regards to food, prices are likely to stay elevated in the years ahead as ramifications of the Russia-Ukraine war. Rising food protectionism and lower agricultural yields due to climate change will also play a role in keeping food supply tight. 

(Related Article: Even with an imminent recession, higher for longer commodity prices will remain. Here’s why)

• Defensive sectors: With a global recession likely unavoidable at this point, investors should consider adding exposure to sectors that are relatively more resilient than others in a recessionary environment. Examples of such sectors include healthcare as well as consumer staples.

Table 5: Recommended products for tactical ideas 

9. This decade should belong to India

• India may benefit from a less constructive outlook for China as investors rotate into Indian equities within emerging markets. Due to its wage advantage, a pro-business environment, and government incentives, we believe that India is a prime location for international supply chains as businesses start to diversify away from China, a trend that is accelerated by the ongoing US-China tensions, as well as China’s shift away from a manufacturing/export growth model.

• The nation also benefits from secular domestic tailwinds, such as a rising middle class and a relatively young population, both of which will support the long-term growth prospects of India, especially the consumption story. In addition, economic reforms, such as a reduction in corporate tax rates and the production-linked incentive scheme, should also help to drive foreign investment.

• However, despite the many positives, the growth potential of Indian equities is held back by its unfavourable risk-reward ratio. Indian equities are currently trading at lofty valuations, approximately 17.8X 2024E EPS versus our designated fair PE ratio of 19X. As such, we think that now might not be the right time to invest in India. We urge investors to have Indian equities on their watch list and wait for valuations to become more palatable before entering the market.

Figure 8: Earnings forecast and price performance of the Sensex Index

Table 6: EPS and upside projection for the Sensex Index 

• Recommended products for India 

o UTI India Dynamic Equity SGD

o iShares MSCI India ETF (BATS:INDA)

10. Peak USD in 2023

• The USD has had a strong run this year. Year-to-date, the dollar index has rallied by as much as 19%, largely driven by a sharp rise in policy rates. Thanks to the wider interest rate differential between the US and the rest of the world, US assets have provided a higher rate of return, which in turn increases the demand for the USD. Aside from the wider interest rate differential, the robust economic strength of the US relative to other countries has also increased the USD’s attractiveness as a safe haven currency.

• Moving forward, with the Fed expected to slow the pace of rate hikes, the main catalyst behind the USD’s appreciation in 2022 is effectively lost. Secondly, a weakening US economy should also lead to a weaker USD, and this effect is exacerbated especially if global growth weakens less than the US. Lastly, the wider trend of de-dollarisation may also eventually lead to lower demand for the USD in time to come.

• Last but not least the USD is likely overvalued. After the sharp rise in 2022, we believe that the USD strength has hit a ceiling. Based on the Real Effective Exchange Rate (REER), the USD is now more than two standard deviations above its historical average, a level that has proven to be unsustainable in the past (Figure 9).

Figure 9: Based on the REER, the USD is now more than 2 standard deviations above its historical average

Declaration:

For specific disclosure, at the time of publication of this report, IFPL (via its connected and associated entities) and the analyst who produced this report hold a NIL position in the abovementioned securities.