Market Outlook: Buy the dip? No, it’s time to buy bonds.

• The optimism that started this year has started to fade, as the rapid repricing of interest rate expectations has led to a broad-based decline across assets.

• While inflation expectations have risen sharply over the month, they still look optimistic. Investors are likely still underestimating the persistence of inflation.

• Given the uncertainties over inflation and the Fed’s monetary policy trajectory, as well as the downside risks to the global economic outlook, we believe it is time to buy bonds.

• Within equities, we believe investors should adopt a value-tilt in their equity exposures given our expectations that both inflation and interest rates will likely remain higher for longer.

• For investors looking to buy the dip in equity markets, hold your horses. We believe 2023 is shaping up to be yet another challenging year. They should be buying bonds instead.

The optimism that started this year has started to fade. Following a blistering start to the year, a reality check has hit financial markets: higher-than-expected inflation has once again forced investors to recalibrate their expectations on how high the Federal Reserve will raise interest rates.

A month ago, the Fed funds futures market, which indicates market expectations for future interest rate changes by the central bank, reflected expectations that the Fed will bring its policy rate to a peak below 5%. The market was also forecasting the Fed would deliver more than one cut by year-end.

However, the release of the PCE price index, which showed inflation picking up unexpectedly after several months of declines, prompted a wholesale repricing of interest rate forecasts. Investors now expect US rates to peak at 5.4% (as of 28 February 2023), with a slim chance that it could go as high as 6%. Meanwhile, the probability of rate cuts this year has receded significantly, with markets no longer expecting the Fed to cut rates in 2023.

The rapid repricing of interest rate expectations has led to a broad-based decline across assets from equities to fixed income and commodities. Global equities, measured using the MSCI AC World Index, fell by -2.8% in February. Bonds were harder hit, with the Bloomberg Barclays Global Aggregate Index chalking up losses of -3.3% over the month (returns in local currency terms as of 28 February 2023).

For investors looking to buy the dip in equity markets, here’s our advice: don’t. With investors still betting that long-run inflation will come back under control, and that earnings and profit margins will stay high, there is still scope for downside surprises.

Inflation expectations still look optimistic

Inflation expectations have risen sharply over the month. The one-year inflation break-even rate – a market-based measure of expected inflation – has jumped to 3.4% at the end of February, up from just 2.0% one month ago, a remarkable rise in a span of just four weeks, as signs of persistent price pressures suggest the Fed still has a lot more work to do before it gets inflation under control.

Yet, inflation expectations still look optimistic.

As the Fed’s preferred inflation gauge is the PCE price index, which grows more slowly than CPI, investors’ expectations imply the central bank will be able to bring inflation down to near its 2% target by early 2024. We have been highlighting in our research articles since 2022 that inflation is likely to take much longer than what markets are currently expecting to come down to 2%. We continue to hold this view. There are reasons to believe that the Fed will struggle to achieve its inflation goal in such a short period.

Firstly, the labour market remains incredibly robust. This has been underscored by January’s jobs report, which reported nonfarm payrolls increasing to 517,000, more than double the 189,000 increase expected by economists. The strength in labour demand has also occurred alongside the weakness in labour supply, with the labour force participation rate remaining well below pre-Covid levels (Chart 1). In the longer term, slowing population growth and an ageing population will further constrain labour supply. With labour costs accounting for about two-thirds of the CPI, a tight labour market could continue to exert upward pressure on inflation.

Chart 1: Labour force participation rate remains below pre-Covid levels

Secondly, disinflation does not happen in a straight line. The drivers of the recent disinflationary episode could be themselves transitory. For instance, the steep decline in used car prices has been a major factor in the slowing of inflation. However, this is about to change. The strong labour market has been driving demand for used cars, leading to higher wholesale prices. Another worrying possibility is a resurgence of commodity prices, particularly as China reopens its economy. Inflation is now so broad-based that any unexpected supply shocks or unforeseen developments could trigger another inflationary surge.

Lastly, 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: (1) shortages in commodities due to the structural under-investment in supply; (2) labour shortages due to an ageing population and a broader decline in immigration; and (3) deglobalisation.

We see longer-term inflation settling at around 4% and believe investors are still underestimating the persistence of inflation. In case anyone thought that inflation would be easy to control, here is some bad news: based on historical data, inflation across advanced economies has taken an average of 10 years to return to 2% once it breaks above 5%, according to Bank of America. Rarely has inflation fallen that much, so quickly. Even if it did, the process was not without pain.

Related articles:

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It’s time to buy bonds!

It has been one year since the Fed embarked on its most aggressive monetary policy tightening since the 1980s. The fight against inflation, however, remains far from over, with a great deal of uncertainty still surrounding the Fed’s monetary policy trajectory.

As Fed Chair Jerome Powell has noted, the Fed’s tightening of monetary policy can be assessed along three dimensions: how quickly it raises rates, how high it raises them, and how long it then keeps them there. The first dimension is already clear. After initially falling behind the curve on inflation, the Fed's recent tightening path has easily outpaced anything in recent decades. However, there is still a great deal of uncertainty surrounding the other two dimensions.

The second dimension remains far from certain. With inflation still well above the Fed’s target, there’s growing concern that more interest rate hikes will be needed, even more than central bank officials anticipate. A once almost outlandish 6% peak rate is no longer seen as a remote possibility. Another big market fear is that the Fed will cause a recession with its rate hikes. The biggest uncertainty surrounds the final dimension. While Mr Powell has warned that rates would have to stay at restrictive levels for “an extended period”, the jury is still out on how long this “extended period” will be.

Given the uncertainties over inflation and the Fed’s monetary policy trajectory, as well as the downside risks to the global economic outlook, we believe it is prudent for investors to adopt a more defensive positioning for their portfolios i.e., it’s time to buy bonds.

On its own, the fixed income asset class has become increasingly attractive. Following the brutal sell-off last year, global bond yields have climbed to levels that were last seen during the global financial crisis. Investment grade bonds no longer give paltry yields of below 2%. They now offer a yield of about 3.84%, providing more than two times the S&P 500 estimated dividend yield of 1.78% in 2023 (as of 28 February 2023). Across the board, yields have picked up substantially, providing investors with a real alternative to the stock market.

Moreover, the valuations of bonds have turned much more attractive as compared to equities, as seen from the tightening spread between earnings and bond yields. The spread has reached 2.6%, which is one of its lowest points on the record and is also nearly two standard deviations below the long-term average since 2009 (Chart 2). In other words, investors are now poorly compensated for taking on equity risk.

Chart 2: Bonds are increasingly more attractive compared to equities

Besides, investors are still placing a great deal of faith in corporate earnings resilience even as macroeconomic conditions remain challenging, with earnings estimates remaining rather optimistic. The consensus forecast for the MSCI AC World Index indicates flat earnings growth in 2023. Considering that past recessions have typically resulted in double-digit earnings declines, there could be further earnings downgrades, especially if a recession materialises. Meanwhile, operating margins are expected to surge to an all-time high of 14.8% (Chart 3), above pre-pandemic levels of 11.5% and the five-year average of 12.1%.

Chart 3: Operating margins are estimated to hit all-time high in 2023

Granted, both fixed income and equities will suffer if inflation turns out to be more persistent than expected. However, if investors buy bonds now, they are at least buying them at very attractive valuations. The same cannot be said for equities. Equity valuations have indeed gotten cheaper over the past year, but at 15.5X estimated earnings in 2023, they do not look dirt cheap relative to historical standards (Chart 4).

Chart 4: Global equities may look cheaper, but they are not dirt cheap!

As such, we believe this is the ideal time for investors to be buying bonds, especially short duration bonds, with the likes of the Nikko AM Shenton Short Term Bond SGD, the United SGD Fund Cl A Acc SGD, and the LionGlobal Short Duration Bond A Dis SGD all sporting attractive average portfolio yields of around 5%.

However, this does not mean investors should have no exposure to equities at all. Far from it. We believe investors should always maintain a diversified portfolio of stocks and bonds. A preference for fixed income can be expressed via an overweight position in their portfolios i.e. allocating a higher-than-normal percentage allocation to fixed income compared to equities.

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Value stocks to continue outperformance relative to growth

Within equities, we still prefer value stocks over growth.

Given our expectations that both inflation and interest rates will likely remain higher for longer, we believe value stocks will continue to outperform growth stocks. As such, we believe investors should adopt a value-tilt in their equity exposures.

Growth stocks have outperformed value stocks over the past decade. As this period of outperformance was considerably long, it might be forgotten that in the decade prior to 2010 (i.e. 2000-2009), value had outperformed growth by a wide margin (Chart 5). The massive rotation from value to growth from 2010 onwards was largely a result of ultra-easy monetary policies, as low interest rates can just about justify any valuation for stocks with a good story to tell, profitable or not.

Chart 5: Value outperformed growth from 2000-2009

The end of cheap money, however, means that the next decade could look very different. As we move into a new regime of higher inflation and interest rates globally, the types of companies prized by investors will likely change. The types of stocks that are likely to do well are the cheaper areas of the stock market, and where stock valuations are based on current fundamentals (e.g. free cash flows and balance sheet strength), rather than earnings potential in the distant future. This environment is likely to favour value stocks over their growth counterparts.

A massive rotation back into value stocks could be underway. Even though value stocks have outperformed growth stocks in 2022, they have only just begun to catch up on the many years of underperformance (Chart 6). We expect this outperformance to continue, and it is for this reason we recommend investors to adopt a value-tilt in their equity exposures i.e. incorporate more value stocks in their portfolios compared to growth stocks.

Chart 6: A massive rotation to growth away from value took place from 2010 onwards

But don’t ditch growth stocks just yet.

While growth stocks have lost much of their shine in 2022 amidst soaring inflation and rising interest rates, not all growth stocks are made equal. Some will still remain relevant, especially the high-quality big-tech companies that will continue to disrupt business models. As an added bonus, the big-tech firms already have strong profitability and balance sheets that will enable them to tide through difficult economic conditions. The valuations of high-growth loss-making tech companies, on the other hand, are unlikely to recover.

Related articles:

Rise of the underdog. The comeback of US Value stocks

Value leadership is back – The shield against high inflation and policy rate hike

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Asset allocation moving forward

For investors looking to buy the dip in equity markets, hold your horses! We believe 2023 is shaping up to be yet another challenging year, with a stagflationary environment warranting a more defensive positioning in our asset allocation. As we have highlighted above, this is the time for investors to be loading up on bonds instead of equities. As such, at the asset class level, we retain our preference for fixed income over equities.

Within fixed income, we prefer investment-grade over high yield as a more defensive positioning may be more important in a recessionary environment. In terms of duration, our preference is for short-duration bonds as short-term bond yields have moved significantly higher as compared to long-term yields. Given our view that markets are underestimating the persistence of inflation, we see the potential for long-term yields to move up further. An unconstrained bond strategy is also viable as it allows for better management of interest rate risk in this tough environment.

Within equities, developed markets now look more attractive relative to emerging markets, given our bearish outlook for Chinese equities. Japan remains our top equity market pick due to the following: (1) benefits from reopening tailwinds, (2) strong balance sheets, (3) attractive valuations, and (4) potential rebound in the yen. Furthermore, given our expectations that inflation is likely going to be higher for longer, value stocks and commodity-linked equities will be amongst the winners. Within emerging markets, we favour Latin America and ASEAN equities. ASEAN, in particular, is poised to benefit from the shift of production away from China.

We remain negative on India in the near-term due to its high valuations and the risk of earnings downgrade. While sentiment towards Indian equities has suffered in recent times due to the Adani controversy, India’s compelling secular growth opportunities cannot be overlooked. We urge investors to have Indian equities on their watch list and wait for valuations to become more palatable before entering the market.

Lastly, we believe the USD is likely overvalued after its sharp rise in 2022. Investors should consider hedging away their USD exposure where possible, opting for hedged share classes for products exposed to the USD. We also expect the Japanese yen to reverse higher in 2023 after a significant weakening last year.

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.