MAPS 1Q20 Update: Rough first quarter, but we see light at the end of the tunnel by year-end

Fear and panic quickly manifested in the global financial markets. As the spread of Covid-19 worsens, the risk-off sentiments took hold in the market, resulting in steep selloffs across risk assets like equities and high-yield bonds. The first quarter of 2020 (1Q20) marks the worst quarterly performances of global equities since the 2008 Great Financial crisis.

While there has not been a place for market participants to hide in the current backdrop, apart from holding cash, our portfolios were slightly cushioned by our higher exposure to Asian and Chinese equities, and our smaller exposure to US and Europe equities. Asian and Chinese equities have outperformed global equities in 1Q 2020

Amid the sharp pullback in prices of global equities caused by the Covid-19 fears, we simply could not sit on our hands and let opportunities slipped us by. Therefore, upon assessing the market conditions, we have made two changes to our portfolios and implemented them in the month of February. The two changes are: (i) extend our equity overweight by another 2.5% and (ii) downgrade Japan from overweight to neutral.

While global markets have shifted, moving from a secular bull market to a (hopefully short) bear market, our strategy have not changed. Our valuation–driven methodology, focusing on fundamentals and a GDP-weighted allocation have benefited us and we remained committed to it.

We encouraged investors to stay invested and disciplined to their long-term investing objectives. We believe much of the negatives have already been priced into the markets. Both prices and valuations of risk assets have fallen sufficiently enough that the upside potentials of investing into them now outweighs the downside risks.

The first three months of 2020 have been very difficult for investors and market participants. Despite starting the year on a strong footing, on the back of receding trade tensions between the US and China, that optimism in global equities quickly gave way to fear and despair.

The sudden emergence of a highly infectious novel Coronavirus (Covid-19), which rapidly roiled across the world, has much to blame for this. In mere weeks, it has infected and killed thousands of people, causing a massive global health crisis.

In response, governments have imposed strict travel restrictions and social distancing measures to crack down on the spread of the Covid-19 pathogen within its populace. Aside the terrible loss of human lives, the damage of Covid-19 has also extended into an economical one, as certain industries like travel and retail face steep declines in revenue and global supply chains face disruptions.

As we round up the tumultuous first quarter of this year, it would be timely for us to update investors on what we have done for the portfolios, as well as some of our thoughts moving forward.

1Q 2020 marks one of the worst quarters since 2008 Financial Crisis

Fear and panic quickly manifested in the global financial markets. As the spread of Covid-19 worsens, the risk-off sentiments took hold in the market, resulting in steep selloffs across risk assets like equities and high-yield bonds. In the first quarter of 2020, almost all the major equity regions and fixed income segments under our coverage have posted losses, with no place to hide in financial asset (Chart 1).

On a quarter-on-quarter basis, the first quarter of 2020 (1Q20) marks the worst quarterly performances of global equities since the 2008 Great Financial crisis. Global equities (as measured by MSCI AC World Index) fell -21.7% (in USD terms) across the three months, among which emerging markets outside of Asia declined the most.

Chart 1: Global equities faced steep declines as Covid-19 sweep across the globe

The portfolios benefitted from our overweight on Asia and China equities

Holding a globally diversified portfolios constructed with equities and bonds, we were unavoidably hit by the sharp selloffs in the global financial markets due to Covid-19 fear. There has not been a place for market participants to hide in the current backdrop, apart from holding cash. As a result, all our portfolios have registered losses across 1Q 2020.

Thankfully, heading into the market meltdown, our intra-asset allocation has worked to lessen the damage sustained by our portfolios. Our portfolios benefitted from our higher exposure to Asian and Chinese equities, and our smaller exposure to US and Europe equities (Table 1).

Table 1: Our portfolios were overweight on Asian and Chinese equities heading into 2020

Fixed Income Portion	Portfolio Allocation	Equities Portion	Portfolio Allocation
Singapore-Centric bonds	Overweight	US	Underweight
Global Bonds	Underweight	Europe	Underweight
Asian Bonds	Neutral	Japan	Neutral
Emerging Market Bonds	Overweight	Asia ex Japan	Overweight
Global High Yield Bonds	Underweight	LATAM	Neutral
US High Yield Bonds	Underweight	China	Overweight
Source: iFAST Compilations. Data as of April 2020.

What investors initially thought was a virus outbreak largely isolated within China and the Asia region started to spread rapidly across the globe and developed into severe health crisis in Europe and US. While China has managed to keep the Covid-19 situation within its country under reasonable control, policymakers and health officials in the US and Europe are only beginning to grapple with the Covid-19 outbreak.

Interestingly, China equities which were hit the hardest on the onset of the Covid-19 outbreak, have almost pared back much of the losses associated to the epidemic. The positive developments arising from massive monetary stimulus (liquidity injections and rate cuts), as well as the declining rate of new infections have boosted investors’ confidence in the Chinese equity market.

Consequently, Asian and Chinese equities have outperformed that of global equities across the 1Q 2020, by 3.1% and 11.7% respectively (in local currency terms). Much of the deviation in performances occurs in March, where business conditions and factory activities are returning to normalcy in China. Recent economic data from China are also provide evidence that its economy is getting back on track, especially as employees can now return to their workplaces (Chart 2).

Chart 2: Asian and Chinese equities have outperformed global equities in 1Q 2020

Two Adjustments made to the MAPS Portfolios in 1Q 2020

Amid the sharp pullback in prices of global equities caused by the Covid-19 fears, we simply could not sit on our hands and let opportunities slipped us by. Therefore, upon assessing the market conditions, we have made two changes to our portfolios and implemented them in the month of February.

The two changes are: (i) extend our equity overweight by another 2.5% and (ii) downgrade Japan from overweight to neutral, which we will discuss in detail in the sections below.

Portfolio action 1 – Increase equity overweight by 2.5%

As global equities faced a sharp sell-off of more than 20%, we noticed that the yields of equities have surged significantly against that of the global fixed income. In other words, equities have become much more attractive than fixed income.

Across February this year, the excess earnings yield of global equities (as measured by MSCI AC World) against the yields of global bonds (as measured by Bloomberg-Barclays global aggregate bond Index) have surged past its one standard deviation above its ten-year average level and was rapidly reaching its two standard deviation, above the 6% mark (Chart 3).

Chart 3: Excess yields of equities have surged against bonds, rendering equities more attractive

This gave us a clear signal that valuations of equities have fallen significantly compared to fixed income, and that we should take this opportunity to accumulate more equities on the cheap in our portfolios. In the last ten years, the excess yield of equities rarely hovers around such high levels and is almost always to retrace back to its average level, once the markets regain sanity.

Hence, we struck at the opportune time to further extend our equity overweight by another 2.5% against fixed income, on an inter-asset allocation basis. This move brought our total equity overweight from the original +5.0% to +7.5% across our portfolios (except for the Aggressive portfolio – as it has reached maximum equity allocation). We believe that this additional equity overweight will place our portfolios in a better position to generate strong returns, once global equities eventually recover from their current weakness (Table 1).

Table 2: New asset allocation in MAPS portfolios after the additional +2.5% equity overweight

Portfolios	Equities (%)	Bond (%)
Conservative	17.5%	82.5%
Moderately Conservative	37.5%	62.5%
Balanced	57.5%	42.5%
Moderately Aggressive	77.5%	22.5%
Aggressive	90.0%	10.0%
Source: iFAST compilation. Data as Apr 2020.

Portfolio action 2 – Downgrade Japan from overweight to neutral

In early March, we brought our allocation for Japanese equities from an overweight position to neutral. Our tactical decision was motivated by huge near-term downside in Japan’s economic growth and its

Japan’s economic growth was already faltering prior to the outbreak, with 4Q 2020’s GDP growth contracting -1.8% on a year-on-year basis (largest contraction since 2014). COVID-19 not only induced a severe economic shock in Japan through (i) manufacturing and exports as major trading partners (Europe, US and China) were hit hard, (ii) services sector paralysed with stringent quarantine measures, (iii) delay of the 2020 Tokyo Olympics, which is a much-needed growth booster.

The combination of near-term headwinds tilt risks to Japan’s economic growth heavily to the downside. From the corporate perspective, We also expect earnings to decline significantly for the first half of 2020 in a backdrop of rapidly mounting near-term headwinds. As seen from chart x, Japanese equities have historically performed undesirably in a contractionary economic growth environment.

Despite a decline of more than –20 % since 17 January, we believe Japanese equities have yet to price in the full economic damage and earnings impact from COVID-19. Compared to other Asian economies, we expect Japan to take a larger economic hit and faced a more severe contraction to economic growth in 1Q to 2Q 2020. Therefore, we believe it is prudent approach to scale our allocation down from overweight to neutral, reducing the exposure to Japanese equities.

Chart 4: Japan’s economic growth was already faltering prior to the COVID-19 outbreak

Chart 5: Poor economic performance has always negatively impacted Japanese equities

Have our strategy changed?

While global markets have changed, moving from a secular bull market to a possible bear market, our strategy have not change. Our valuation–driven methodology, focusing on fundamentals and a GDP-weighted allocation have benefited us and we remained committed to it.

In a recessionary environment, we expect to see a plunge in equities valuation across markets as discussed above. Ironically, we are now faced with an expanded basket of cheap equities, but security selection remains even more crucial to find those that were greatly discounted. Because when market recovers and valuation re-rates, we want the upside potential to offset initial losses. Hence, our valuation driven approach is even more important in our security selection process.

We recognise that valuation levels right now may unveil certain opportunities in both equities and fixed income markets, but we are equally cognisant of the risks in these asset classes. Such risks may amplify in a recessionary environment and they are credit risks, currency risks, commodity price volatility and interest rate volatility. Moving forward, we will also be putting additional emphasis on risk management to minimise the downside.

Taking into account market developments and conditions over the past 2 months, we have made adjustments (as discussed above) to our intra-asset allocation (Table 3 and 4) Overall, we have become more prudent in our selection and risk management, which we deem apt in the current environment.

Table 3: MAPS Portfolio fixed income allocation

Fixed Income Portion	Neutral	Current Weight	Current Stance
Singapore-Centric bonds	30.0%	32.5%	Overweight
Global Bonds	20.0%	15.0%	Underweight
Asian IG Bonds	15.0%	15.0%	Neutral
Emerging Market Bonds	10.0%	12.5%	Overweight
Global/US High Yield Bonds	15.0%	12.5%	Underweight
Asia High Yield Bonds	10.0%	12.5%	Overweight
Source: Bloomberg Finance L.P., iFAST compilation. Data as of Apr 2020.

Table 4: MAPS Portfolio equities allocation

Equities Portion	Neutral	Current Weight	Current Stance
US	24.0%	19.0%	Underweight
Europe	24.0%	21.5%	Underweight
Japan	6.5%	6.5%	Neutral
Asia ex Japan	27.5%	32.5%	Overweight
China	5.0%	7.5%	Overweight
Emerging Markets ex Asia	6.5%	6.5%	Neutral
Latin America	6.5%	6.5%	Neutral
Source: Bloomberg Finance L.P., iFAST compilation. Data as of Apr 2020.

Equities: Valuation unveils opportunities in Asia

From a valuation perspective, most markets have turned cheaper after the recent sell-off even after factoring in the decline in earnings. This is evident from chart 6 and 7, where the former highlights valuation for major markets after accounting for the estimated earnings decline. The latter chart showed our team’s expectation for earnings growth/ contraction for FY2020 (on a YoY basis) after factoring in the recessionary impact.

Both charts showed that China (A and H-shares) and Asia ex Japan equities were over-discounted and offers larger upside potential. Additionally, cheaper valuation levels provided downside protection to the recent selloff and our portfolio’s overweight position benefited from a risk perspective.

Being hit early by the pandemic and with stringent health measures, China and many Asian countries were able to contain the outbreak early. We expect Asia, particularly China, to lead an economic recovery from the global economic recession and for equities in the region to rebound faster. As such, we added exposure to Asia ex Japan (after bringing Japan’s allocation back to neutral) as a tactical play on the recovery narrative.

Chart 6: Majority of our key markets are trading below fair value even after our earnings adjustments

Chart 7: After adjustments, majority of key equity markets should see hefty earnings decline

Equities: Retain underweight US and Europe

With the sharper pullback in prices of US and European equities, valuations have generally fell from their overvalued levels, towards our fair PE value allotted to these markets. However, valuations are still not as attractive comparatively to the Asian markets, given their highly expanded PE multiples before the outbreak (leading to huge re-rating) and significant impacts on earnings ahead.

On the Covid-19 front, the US and most European countries have not yet managed to flatten their infection rate curves, signalling that outbreak in these countries are still far from peaking. Using China’s COVID-19 curve as a benchmark, it suggests that both the US and Europe will need anywhere between 1-2 more months of stringent health measure to contain the pandemic. Stringent health measures (i.e. lockdown, social distancing etc.) would translate to deep economic impacts in and thus, we expect severe cuts to earnings in 1Q and 2Q 2020 for both region’s equities.

However, given the significant decline in prices and valuations since the start of the year, we think that these markets now warrant a closer look. We will be watching the upcoming economic data releases and earnings reports in the US and Europe equities for an opportunity for us to upgrade our underweight positions on these markets.

While we are expecting a severe hit on economic growth and earnings for US and European equities, we think much of the negatives are already priced in at the current juncture. Even though we opt to maintain our underweight position now, we may take up on a more optimistic stance on the US and Europe equity markets in the coming weeks and months, if things are turning out to be less severe than what we expect.

Fixed Income: Overweight Asian High Yields

As investors grew increasingly concerned over the deterioration in credit and liquidity conditions in financial markets all around the world, credit spreads of high yield bonds have widened significantly. Even though returns of high yields are generally very attractive now, we opt to be selective, favouring only the Asian high yields, while remaining cautious on global and US high yields.

For the Asian high yields, the surge in credit spreads of high yields implied that default probability is reaching that of previous two recessions. However, while we see high likelihood of recession, we think the recession this year is likely to be milder than that of the past two, especially in China, where the Covid-19 situation has been reasonably contained, business conditions and factory activities returning to normalcy (Chart

Hence, while we acknowledge that default rates can pick up, we think that it is unlikely to spiral out of control, given the accommodative monetary and fiscal policies we have seen thus far. Chinese policymakers have been injecting massive amount of liquidity into the economy since the start of the Covid-19, to ensure that workers stay employed and businesses will not run in operating cash flow issues.

It is worth noting that a massive portion of Asian high yield bonds are issued by the Chinese property developers, whose credit health came under intense scrutiny given their highly leveraged nature. Despite the gloomy outlook, we see positives ahead for the Chinese developers (and their ability to service their debts).

Firstly, lower mortgage rates (due to interest rate cuts) will likely stimulate housing demand ahead. Secondly, we expect to see more regulatory support towards the real estate industry via deferred tax payments and loans on preferential terms. In addition, the aggregate home sales in China over the Jan-Feb period are still largely in line with that of previous years.

Chart 8: The current credit spreads of Asian High Yield have surged more than three times its average default rates.

Fixed Income: Underweight on US and Global High Yields

On the other hand, credit conditions of US High Yields and EM high yield have deteriorated on the duo headwinds of the Covid-19 and oil price shock, significantly raising the risk of defaults and possible loss of capital. Hence, despite credit spreads are now very appealing, we remain cautious on these two credit segments and will opt to remain underweight on them.

For the US high yields, a hefty portion of these bonds are issued by US energy companies, which generate their revenue from shale production. Most shale operations are unprofitable at current low oil prices and will be forced to shut production. Coupled with US being in the late stage of its credit cycle, we think a surge in defaults seems likely, and thus the outlook of US high yields will remain pessimistic ahead.

Similarly, the sizable exposure to oil-producing EMs within the EM high yields space also make the segment highly vulnerable to credit downgrades ahead.

For oil-exporting EM in regions such as Middle East, Africa, Russia and South East Asia, an extended period of low oil prices will have adverse effects on public debt dynamics, external balance and economic growth. Many of these economies rely heavily on their oil sectors as a significant source of their tax revenue. The oil weakness is likely to limit the policy space that governments can tap on to stimulate the economies and render it increasingly difficult for them to balance their fiscal budgets ahead.

Stay disciplined towards our long-term objectives, while market conditions recover in the next 6-12 months

While the recent wild sell-off and elevated volatility can inflict massive mental stress on investors, it can create opportunities. We believe that the best investment opportunities often present itself whenever the world faces a challenging but temporary problem, just like the current Covid-19 crisis that have befall on global financial markets.

We encouraged investors to stay invested and disciplined to their long-term investing objectives. We believe much of the negatives have already been priced into the markets and any panic selling now only serve to materialise the paper losses in the portfolios. Both prices and valuations of risk assets have fallen sufficiently enough that the upside potentials of investing into them now outweighs the downside risks.

At the same time, investors could take the opportunity to invest some more of their cash holdings into portfolios, to take advantage of the current low asset prices. While a global recession is inevitable this year (given the weakness in Q1 and Q2), but a V-shaped rebound – in both economic and markets – is currently in the cards by second half of this year.

With markets inherently forward-looking (3-6 months), we think equities and fixed income assets are poised to recover from their recent selloffs once the global Covid-19 situation is kept under reasonable control.

The Research Team is part of iFAST Financial Pte Ltd.

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