MAPS 3Q22 update: Four key changes to best position our portfolios in 4Q

For 3Q, our MAPS Growth portfolios delivered returns of between -3.5% to -5.9%, while our Income portfolios delivered returns of between -3.3% to -5.3%. Most of our portfolios beat their respective benchmarks, with the Moderately Aggressive and Aggressive portfolios (for both Growth and Income) being the exceptions.

The outperformance relative to the benchmark was largely attributed to our portfolio’s resiliency in August and September, during which the portfolios recorded smaller declines. We managed to avoid a steep drawdown given our i) underweight in US, European equities, and the longer-duration digital economy stocks, ii) exposure to Value stocks, and iii) outperformance in our fixed income fund picks.

To better defend against the ongoing risks, as well as to capture opportunities from market sell-offs, we made the following changes in September: i) increased fixed income exposure, ii) increased allocation to Chinese equities and reduced allocation to European equities, and iii) added exposure to China tech.

The quarter in summary

Equity and fixed income rallied in early summer as risk-on sentiment took over on hopes of a dovish Fed pivot and a perceived peak in inflation. This rally was short-lived, however, as optimism was swiftly snuffed out after August’s Jackson Hole conference, during which policymakers reaffirmed their commitment to hike rates. This led markets to reprice policy rates higher, fuelling a sharp sell-off in asset classes that reversed the summer gains.

The risk-off sentiment escalated in September after the Fed again defended its hawkish stance through a jumbo 75bps hike while signalling their intention to raise rates until inflation is subdued. Meanwhile, headwinds also intensified elsewhere around the world, with China’s Covid-19 concern, Europe’s energy crisis, and an escalation in the Russia-Ukraine war dominating news headlines. As risk sentiment collapsed under the weight of mounting headwinds, the sell-off in both equity and fixed income deepened, extending their year-to-date (YTD) losses even further in 3Q22.

In the third quarter (Table 1), global equities (gauged by the MSCI AC World Index) fell by -3.6%. However, the decline was much sharper in USD (-6.7%) as the greenback rose 7% in 3Q (gauged by the DXY Index). As seen from Chart 1, the USD has appreciated dramatically relative to major G10 and EM currencies, magnifying the sell-off in local currency terms. LATAM, EMEA, and US equities did relatively well while China, Asia ex-Japan, and Europe fared poorly. LATAM equities, in particular, managed to generate positive returns of 7.2% (in SGD terms) in an otherwise volatile and risk-off quarter. Similarly, global bonds (gauged by the Bloomberg Barclays Global Aggregate Bond Index) fell by -6.9% in the quarter. Asia high yield and emerging market hard currency bonds fared poorly, while US high yield bonds saw the least decline (in local currency terms).

Table 1: Equity and fixed income market 3Q and YTD returns

Chart 1: The dollar has risen significantly against both G10 and EM currencies YTD

How did our portfolios perform in 3Q?

In terms of performance, our MAPS Growth portfolios delivered returns between -3.5% to -5.9% in 3Q, mostly beating their respective benchmarks with the exception of the Moderately Aggressive and Aggressive portfolios. Our MAPS Income portfolios delivered marginally stronger returns between -3.3% to -5.3% in the same period. Similarly, all Income portfolios, except the Moderately Aggressive and Aggressive portfolios, managed to beat their respective benchmarks.

The outperformance was largely attributed to our portfolio’s resiliency in August and September, during which our portfolios recorded smaller declines relative to the benchmark (Table 2). We managed to avoid a steep drawdown when the Fed doubled down on its aggressive stance given our i) underweight in US, European equities, and the longer-duration digital economy stocks, ii) exposure to Value stocks, and iii) outperformance in our fixed income fund picks.

Our Income portfolio’s stronger performance relative to its Growth counterpart can be attributed to the outperformance of certain funds - namely the more resilient, defensive-oriented ones which the income portfolios contain.

Table 2: MAPS Growth and Income Portfolio performance in 3Q

Latest changes to the portfolios

In our latest round of rebalancing, we made the following changes to our portfolios (Table 3). For the remainder of this article, we will outline our rationale for these changes.

Table 3: List of recent changes

1. Reduced fixed income underweight i.e. increased exposure to fixed income

Over the quarter, we reduced our fixed income underweight i.e. we increased our portfolio exposure to the fixed income asset class, as we are increasingly finding fixed income attractive after the protracted sell-off. Widening credit spreads across the segments have pushed yields to levels not seen in a long time. Investment grade bonds, in particular, are now offering attractive yields for a decent credit profile. Valuations have also become more attractive across many bond segments, with above-average spreads after a significant widening this year. Fundamentally, the majority of global bond issuers – especially issuers of higher credit quality - are in a better shape today and we believe healthier credit metrics can provide some cushion during a cooling growth backdrop.

Moreover, the valuations of bonds have turned much more attractive as compared to equities. We compare this by looking at the yield of global bonds relative to the earnings yield of global stocks. A higher premium implies greater value in equities than bonds (and vice versa), as investors could receive higher potential returns from holding equities which are riskier. In the current environment of rising rates, the surge in bond yields has far outpaced the increase in earnings yield. The result has been a tightening spread between earnings and bond yields (fixed income turning relatively more attractive) (Chart 2).

Chart 2: Excess yield are near historical lows, suggesting that the premium for equities over fixed income on a yield basis has greatly diminished

While we remain overweight equities, we are turning more cautious as policymakers’ commitment to an aggressive stance continues to raise the risk of a hard-landing which will challenge risk assets. We continue to find earnings estimates optimistic, especially for developed markets, and further downgrades will be in tow as macro risks mount and margins rollover.

As such, we believe it pays to move up in quality and cut risk. To express this, we have reduced our fixed income underweight i.e. increased our fixed income exposure (accompanied by a reduction in equity overweight), thereby increasing our exposure to higher quality fixed income segments like the SGD-centric short duration bonds and global bonds, which collectively make up more than half of our fixed income exposure.

Table 4: Current inter-asset allocation

2. Increased allocation to Chinese equities

We remain positive on China equities despite the sharp sell-off this year and have increased our China equities exposure from 7.5% to 10.0%. The nation’s policy backdrop remains accommodative and is more supportive for equities relative to the developed markets (DMs). China has also been ramping up efforts to bolster growth through a multitude of fiscal and monetary stimulus while DMs are expeditiously hiking policy rates to combat inflation. While we believe China is unlikely to budge from its zero-Covid policy, new restrictions are likely to be more targeted, with consideration given to potential economic impact.

Markets are also likely to be overly pessimistic on the earnings outlook for Chinese companies as seen from heavy handed EPS downgrades since the year began. Given the downgrades and sell-off, we believe the risks in China’s equity market has been largely been discounted by markets. This is also reflected in valuation levels which is trading at a steep discount.

3. Reduce allocation to European equities

On the contrary, we have turned negative on European equities and have cut European equities from Neutral to Underweight, reducing allocation from 21.5% to 19.0%. The spike in energy prices has propelled Europe’s inflation higher, prompting the European Central Bank (ECB) to respond aggressively with jumbo-sized rate hikes that should weigh on growth moving forward.

The energy crisis has forced policymakers to enact energy rationing measures that are hurting the output for key industries (such as automobile), likely resulting in more economic drag. Our team thinks the energy crisis is unlikely to be resolved quickly, which means the economic pain may persist longer than expected. On the earnings front, Europe’s weakening macro backdrop warrants a downgrade, but analysts have so far been optimistic, potentially setting up ample room for disappointment. While European equities have undergone a sharp correction this year, we see the potential for more earnings downgrades given the deteriorating economic outlook.

The absence of a catalyst also means that European stocks are unlikely to stage a quick rebound, at least in the short-term. As such, we remain cautious over Europe, and have opted to downgrade the market to an Underweight position.

4. Added exposure to China Tech

In our view, China tech is looking more attractive after a near 40% sell-off year-to-date (as of 30 September 2022, in local currency terms). We believe one of the sector’s biggest risks, the regulatory headwind, is steadily easing and the recent decline in intervention by policymakers further strengthens our belief. Even as risks have receded, the valuation for the Hang Seng Tech Index has continued to trade at depressed levels (forward PE trading at a 26% discount to the long-term average), suggesting that many negatives have been priced in. Despite earlier regulatory crackdowns, Chinese big tech firms continue to deliver resilient earnings results and the sector offers one of the strongest growth amongst Chinese equity sectors.

Supported by an improving outlook and attractive long-term growth potential, we decided to add exposure to China tech via the iShares Hang Seng TECH ETF. While a moderation in China’s growth and the global hawkish rhetoric may weigh on the sector’s performance, we see limited downside given depressed valuation levels that provide a wide margin of safety.

Current equity and fixed income positioning

After the changes in September, our portfolios are +2.5% overweight equities and -2.5% underweight fixed income. Within equities, we are overweight Asia ex-Japan, China and Japan, while we are underweight the US, Europe and digital economy. We stay neutral on LATAM and EMEA.

Within fixed income, we are overweight SGD-centric short duration and Asia high yield bonds, while we maintain underweight positions in Asian investment-grade, emerging market and global/US high yield bonds. We remain neutral on global bonds.

Table 5: Portfolio equity positioning

Table 6: Portfolio fixed income positioning

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.

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MAPS 3Q22 update: Four key changes to best position our portfolios in 4Q

The quarter in summary

Table 1: Equity and fixed income market 3Q and YTD returns

Chart 1: The dollar has risen significantly against both G10 and EM currencies YTD

How did our portfolios perform in 3Q?

Table 2: MAPS Growth and Income Portfolio performance in 3Q

Latest changes to the portfolios

Table 3: List of recent changes

1. Reduced fixed income underweight i.e. increased exposure to fixed income

Chart 2: Excess yield are near historical lows, suggesting that the premium for equities over fixed income on a yield basis has greatly diminished

Table 4: Current inter-asset allocation

2. Increased allocation to Chinese equities

3. Reduce allocation to European equities

4. Added exposure to China Tech

Current equity and fixed income positioning

Table 5: Portfolio equity positioning

Table 6: Portfolio fixed income positioning

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