Here's how we are preparing our portfolios to survive a rocky 2023 (and how you can too!)

• Markets have suffered this year under a toxic combination of rising interest rates and high inflation. The year ahead will not be any easier, with a global recession looming in the background and inflation likely to remain stubbornly high.

• We have recently fine-tuned our FSM Managed Portfolios with four changes in preparation for what we think could be another challenging year ahead.

• The changes include: (1) increasing fixed income allocation to Neutral, (2) downgrading China to Neutral, (3) downgrading Asian high yield bonds to Neutral, and (4) including ASEAN equities in our tactical portfolios.

• At the asset class level, we prefer fixed income over equities. Within fixed income, we prefer short-duration bonds and global bonds. Within equities, we prefer the US and Japan. With inflation higher for longer, we also like value stocks and commodity-linked equities.

• The crash this year means that valuations across equity and fixed income markets have come down substantially compared to a year ago. We can have some optimism that future expected returns are now much higher than the rock-bottom levels of recent years.

Even though 2022 is the year of the tiger, bears have so far stolen the show.

Markets have suffered this year under a toxic combination of rising interest rates and high inflation. The slump has been painful, as can be seen from the -14.6% plunge in global equities. Once the darling of investors, tech stocks have already lost close to one-third of its value this year. Meanwhile, speculative assets from cryptocurrencies to meme stocks and special-purpose acquisition companies (SPACs) have all been crushed. Even the supposedly safer fixed income assets have not escaped the rout either, with global bonds falling -16.7% so far in 2022 (returns as of 30 November 2022).

The year ahead will not be any easier, with a global recession looming in the background and inflation likely to remain stubbornly high. As such, we have recently fine-tuned our FSM Managed Portfolios with four changes in preparation for what we think could be another challenging year ahead.

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1. We increased our fixed income allocation to Neutral

Over the month, we increased our fixed income allocation to Neutral, as we continue to see attractive value emerging within this asset class. Following the brutal sell-off in fixed income markets this year, global bond yields have climbed to levels that were last seen during the global financial crisis. Across the board, yields have picked up substantially, providing investors with the potential for higher total returns, and a relatively attractive entry point.

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 2.9%, 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 1). In other words, investors are now poorly compensated for taking on equity risk.

Chart 1: Bonds are increasingly more attractive compared to equities

Besides, as we’ve highlighted in one of our recent articles, we believe that inflation is in a structural shift, characterised by shortages in commodity and labour markets. Deglobalisation will also add to long-term inflationary pressures. As such, we expect inflation to be more persistent than what investors are expecting – not even a recession can tame inflation. This also means that the Fed is unlikely to cut rates anytime soon, and interest rates will remain 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. Against this backdrop, we believe adopting a more defensive positioning (i.e. increasing exposure to fixed income assets) in our portfolios is warranted at this point.

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2. We downgraded Chinese equities to Neutral

As highlighted in one of our recent reports, we have turned defensive on Chinese equities.

President Xi Jinping’s consolidation of power has set in motion structural shifts that have negatively altered the long-term investment case for China. First, China’s shift to a top-down state-controlled economy could usher in a low-growth period and imperil the long-term profitability of private companies. The risk of policy mistakes will also be higher. Second, China’s foreign policy stance will likely be more assertive, with President Xi steering China away from reconciliation with the West and increasingly adopting a harder line on Taiwan, ushering in a dangerous new era of US-China hostility.

While China has signalled a pivot from its zero-Covid policy in recent times, sparking a huge rally in its equity market, we believe investors are getting ahead of themselves. There are reasons to believe that the recent rally is unlikely to last.

Even as China has moved to ease its draconian zero-Covid policy, the relaxation has come at an inopportune time when Covid-19 cases are surging to record highs. As a result, many areas remain under lockdown. According to an index compiled by Nomura, lockdowns are now in place in cities accounting for about 19.3% of China’s gross domestic product (GDP), equivalent to the size of India’s economy and not too far from a previous peak of about a fifth in mid-April. There are also close to two million close contacts under medical observation, far more than during previous outbreaks. All these have stunted economic activity and consumer confidence (Chart 2).

Chart 2: Mobility in China’s four largest cities by GDP has been significantly curtailed

Furthermore, China has not undertaken the preparations that would be needed for a safe reopening. Its elderly population remains under-vaccinated, while the more effective mRNA vaccines have also not been approved for use. Importantly, with fewer than four intensive care unit (ICU) beds per 100,000 people, China’s healthcare system is currently not equipped to handle an inevitable surge in hospitalisations. A rapid opening at the start of winter could swamp China’s healthcare system and bring about the waves of deaths that the party has so far boasted of avoiding.

Even if China can ramp up its vaccination drive and healthcare resources within a short period (it wouldn’t), a deep-rooted fear of Covid-19 presents yet another roadblock. For the past three years, the Chinese media has portrayed Covid-19 to be such a dangerous virus that China needs to be locked down to combat it. As such, fear of the virus is ingrained in the population. To convince people to live with Covid-19, China will need a whole new public communications campaign.

All these will take time. Even if China were to end its zero-Covid policy immediately, the positive economic effects would not be felt straight away. As such, we reiterate our view that China is no longer an attractive market to invest in. Given the strong rebound in Chinese equities in November, we have taken the opportunity to reduce our exposure.

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3. Downgraded Asian high yield bonds to Neutral

Over the month, we have also downgraded Asian high yield bonds to Neutral. Similar to our investment case for Chinese equities, we think Asian high yield bonds also now come with much higher risks than before, particularly the high yield bonds issued by Chinese property developers.

Even though China has unveiled sweeping measures over the month to support its embattled property sector, success is far from guaranteed. This is not the government’s first attempt at reviving the property sector. Authorities have implemented a flurry of support measures over the course of 2022. Despite all these measures, the property market continued to deteriorate. To add on, the latest measures only benefit a handful of non-defaulting developers.

Furthermore, China’s property market is plagued by a confidence crisis. Homebuyers are not even convinced that developers can deliver the properties that have been pre-sold. To restore confidence, developers will need to finish the uncompleted projects for which homeowners have already paid. However, this will take time, especially if the developers first need to be restructured, a process that could take as long as a year.

China Evergrande, which was declared to be in default in late 2021, is still working to firm up the terms of its debt restructuring negotiations with its bondholders after close to a year. Sunac China only recently unveiled a debt restructuring plan, more than half a year after it first declared default. The restructuring process for the other defaulters will likely be a protracted one. It will also take time for a steady stream of completions to restore confidence in the property market.

Even if prospective homebuyers are confident that a property they purchase will be completed, they may not feel confident enough about their financial situation, given the uncertain economic outlook and falling home prices (Chart 3).

Chart 3: Home sales and prices have been falling

We believe China has reached a point of no return in its battle to contain what could be the biggest property crash the world has ever seen. As things stand, the shift in policy is too little, too late. As such, we no longer think Asian high yield bonds are worth the risk, and believe that there are other more attractive opportunities within the fixed income space.

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

4. We initiated a tactical position in ASEAN equities

Finally, we have initiated a tactical position in ASEAN equities over the month, using the Principal ASEAN Dynamic Fund Class SGD. We believe ASEAN will remain resilient even in the face of a global growth slowdown and is a major beneficiary of a shift in supply chains away from China.

ASEAN has traditionally been an export-reliant bloc. Thus, its economies are likely not immune to the impending global recession that will likely take place in 2023. However, for the bloc, the largest trading partners are situated within Asia, with intra-ASEAN trade accounting for over 20% of exports. This makes ASEAN relatively more exposed to the demand backdrop in Asia, rather than that in the US and Europe. With Asian demand supported by the recent re-opening wave, domestic recovery, and milder inflation headwinds relative to the West, we believe this Asia-focused export mix should help to provide some support for ASEAN economies.

Furthermore, ASEAN has been (and will continue to be) a major beneficiary of a shift in supply chains away from China. According to trade data released by the US, even as the country’s imports have risen by a third since 2018 when Donald Trump waged a trade war against China, the gains have been unevenly distributed. The greatest beneficiaries have been ASEAN countries: exports to the US from Cambodia, Vietnam, and Laos have all seen sharp increases; exports from Thailand are up by 85%; Indonesia has seen its exports grow by more than 60% (Chart 4). In comparison, US imports of Chinese goods stand at just 6% above four years ago.

Chart 4: Gains in US imports have been unevenly distributed

This trend is not limited just to the US. Both Europe and China have also been importing more from ASEAN. Increasingly, ASEAN has been intermediating trade between China and the West. There was initially some hope that Africa and Latin America might be able to attract some of these trade flows. The great champions of the past four years, however, are found in the ASEAN region.

As such, we have decided to initiate a tactical position in ASEAN equities using the Principal ASEAN Dynamic Fund Class SGD.

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Portfolio positioning moving forward

Brace yourselves: a global recession is likely unavoidable in 2023. We also believe that inflation is in a structural shift, with the world 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. As such, 2023 is shaping up to be yet another challenging year, with stagflation warranting a more defensive positioning in our asset allocation.

At the asset class level, we now have a preference for fixed income over equities, as reflected in our decision to increase our fixed income allocation to Neutral (Table 1). Within fixed income, our preference is now for short-duration bonds and global bonds, which we have increased our exposure to after paring Asian high yield bonds back to Neutral (Table 2). 

Table 1: Current inter-asset allocation

Table 2: Intra-asset allocation for fixed income

Within equities, we prefer the US and Japan (Table 3). 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. We also favour Latin America and ASEAN equities. ASEAN, in particular, is poised to benefit from the shift of production away from China.

Table 3: Intra-asset allocation for equities

Fortunately, there is some good news. The crash this year means that valuations across equity and fixed income markets have come down substantially compared to a year ago. Bond yields are now at much higher levels, increasing the income stream to investors, while the lower equity valuations have also increased the likelihood of future returns.

While markets could certainly go lower from here, we can have some optimism that future expected returns are now much higher than the rock-bottom levels of recent years. In the words of Howard Marks, “we’ve gone from the low-return world of 2009-21 to a full-return world”. A portfolio of stocks and bonds can now deliver reasonable returns on a long-term basis. 

Given that market volatility is likely to remain high, at least in the short term, the best way to navigate this uncertain environment is to have a diversified investment portfolio. Not sure where to start? Check out our FSM Managed Portfolios, an online portfolio management service that builds, monitors, and rebalances your portfolio for you continually. From portfolio construction, daily monitoring, regular rebalancing to risk management, we’ve got everything covered so that you have more time to enjoy the better things in life.

So put your feet up, while we do the legwork for you!

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.