Navigating Market Volatility: The latest changes to our MAPS portfolios and why they matter

• The swift collapse of Silicon Valley Bank sent shockwaves across financial markets. As we have been constantly advocating, we believe 2023 is shaping up to be yet another challenging year.

• We have recently fortified our FSM Managed Portfolios with four defensive changes that will give our investors greater security in the year ahead.

• The changes include: (1) increasing fixed income allocation to Overweight; (2) downgrading Asian high yield bonds to Underweight; (3) downgrading Asia ex-Japan and reducing China tech exposure; and (4) including value stocks in our Japan equity exposure.

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

Something broke on 10 March 2023.

Silicon Valley Bank (SVB), the 16th largest bank in the US, failed after it faced a tidal wave of deposit withdrawal requests amidst anxiety over the bank’s health, making it the second-largest bank failure in US history, second only to Washington Mutual. The swift collapse of SVB sent shockwaves across financial markets, taking down Signature Bank along with it. The banking turbulence also spread to Europe, sinking Credit Suisse into its most serious crisis of its 166-year history.

As we have been constantly advocating, 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. Now, with a crisis of confidence afflicting the global banking system, all the more reason to be conservative in our asset allocation. As such, we have recently fortified our FSM Managed Portfolios with four defensive changes that will give our investors greater security in the year ahead.

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1. We increased our fixed income allocation to Overweight

We have been gradually increasing our fixed income allocation over the past few months. In December last year, we increased our fixed income allocation to Neutral. Over the month, we have further increased it to an Overweight position.

With the Fed now having to balance its dual priorities of financial stability and price stability, there is a great deal of uncertainty surrounding the Fed’s monetary policy trajectory. On one hand, the Fed’s fight against inflation remains far from over, suggesting that more rate hikes are required. On the other, turmoil in the banking sector has sparked renewed calls for the Fed to pivot from its tightening efforts. The mounting downside risks to the global economic outlook also means that it is prudent to adopt a more defensive positioning for our portfolios at this point.

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. 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 more than 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: Fixed income has become 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 14.9%, above pre-pandemic levels of 11.5% and the five-year average of 12.1%. This is not realistic in our view.

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 15.4X estimated earnings in 2023, they do not look dirt cheap relative to historical standards. Furthermore, with interest rates expected to remain higher for longer, equities are likely to trade at structurally lower valuations moving forward.

As such, we have decided to increase our fixed income allocation to Overweight.

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2. We downgraded Asian high yield to Underweight

China’s faster-than-expected shift away from its zero-Covid policy and the sweeping measures to support its embattled property sector have led to a sharp rally in Asian high yield bonds over the past few months. However, in our opinion, the rally is likely to be short-lived and we maintain our defensive stance on Asian high yield bonds.

While China has unleashed a wave of supportive policies to revive its property sector, it has so far seen limited success, if any. We have continued to see developers experiencing rating downgrades or defaults on their debt obligations in recent times. Notably, Times China – China’s 51st largest developer by contracted sales in 2022 – defaulted on two US dollar (USD) bonds in January 2023 and is halting payments on offshore notes. Ronshine China has also defaulted on its offshore bond this year – its fourth default in sixth months – in a fresh sign that China’s property crisis is far from over.

Granted, there has been green shoots of recovery. The value of new home sales by the 100 largest developers rose 14.9% year on year, the first increase since June 2021, while the decline in home prices has also moderated, with new home prices falling -1.9% year-on-year in February, compared to the -2.3% decline in the previous month (Chart 2). However, one positive data point does not make a trend and certainly does not paper over the fact that China’s property market remains stubbornly stuck in the doldrums.

Chart 2: China’s property market remains stubbornly stuck in the doldrums

Besides, China’s property market remains plagued by a confidence crisis. Homebuyers are not even convinced that developers can deliver the properties that have been pre-sold. Across China, hundreds of millions of square metres of housing projects remain unfinished. Just 60% of homes that were pre-sold between 2013 and 2020 have been delivered. The misuse of presales proceeds by developers remains fresh in the memories of homebuyers. As such, we believe prospective homebuyers may be reluctant to part with their savings for a home they may never see.

It will take time for developers to finish the uncompleted projects for which homeowners have already paid, especially if they 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. It will also take time for a steady stream of completions to restore confidence in the property market.

With China still struggling to even stabilise its property market, talks of a quick recovery is likely premature. Ultimately, the sector’s full recovery hinges on a return of homebuyers’ confidence, which remains far from certain at this point. For investors hoping for more government support for the sector, don’t count on it. At the annual session of the National People’s Congress (NPC), the government said it would target disorderly expansion in the sector, suggesting that deleveraging will remain the dominant theme.

As such, we have decided to downgrade our Asian high yield allocation to Underweight.

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3. We downgraded Asia ex-Japan to Neutral and reduced our China equity exposure

Since we turned cautious over China, the MSCI China Index has been on a relentless rally. Even though a bullish consensus is emerging for Chinese equities, we prefer to remain cautious as we believe the rally is unlikely to sustain. Given that China makes up more than one-third of Asia ex-Japan, we have also downgraded our outlook for the region.

Make no mistake, the worst is likely over for China’s economy. Economic activity recovered in January and February, with China reporting a rebound in consumer spending, industrial output, and investment this year as the country emerged from almost three years of tough Covid-19 controls. However, it could be premature to celebrate as there are reasons to believe that markets are likely too complacent about the sustainability of China’s recovery.

Firstly, China’s reopening is ill-timed. The dismantling of its zero-Covid policy comes at a time when the rest of the world is slowing down. As such, China’s exports will likely face headwinds in the year ahead, although the extent to which export growth will slow remains up for debate. If exports turn out to be a lot weaker than expected, consumers will have to come out in full force to spend in order to pick up the slack left behind by its exports industry.

Secondly, it remains unclear if any post-pandemic rebound in consumer spending will remain sustainable. Consumer confidence remains fragile, especially with the ongoing crisis in the property market youth unemployment remaining chronically high at 18.1%. It seems consumers are more likely to save than splurge in 2023.

Besides, with local governments saddled with heavy debt loads that were built up amidst Covid-related spending mandates and the downturn in the property market, this reduces the scope for more aggressive measures to stimulate the economy. China’s especially conservative growth target of 5% this year also reflects the reluctance of policymakers to over-stimulate the economy in order to avoid accumulating too much debt.

Thirdly, there are also lingering long-term structural issues to worry about for China. 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. China’s abrupt policy shifts over the past few years also mean that foreign firms are now less confident that their operations will not be disrupted. This will likely accelerate the shift of production facilities away from China, even if it involves higher costs. Rising geopolitical tensions is also here to stay.

While a bullish consensus for the Chinese equity market is emerging on Wall Street, we remain unconvinced. As such, we have downgraded our Asia ex-Japan allocation to Neutral and have also reduced our positions in China tech stocks over the month.

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4. We included the Eastspring Japan Dynamic Fund in our portfolios

Finally, we have included the Eastspring Investments - Japan Dynamic AS SGD in our portfolios. The fund adopts a value-tilt in its Japanese equity exposure, focusing on attractively valued companies that have sound fundamentals and have yet to be fully recognised by the market. Its value-focused approach means that it is a good complement to the JPMorgan Funds - Japan Equity A (dist) SGD, which we currently have in our portfolios and provides exposure to Japanese growth companies.

While we have adopted a value-tilt in our developed market equity exposure since March 2022, primarily for US and Europe, we have opted against a value approach for our Japan exposure as we believed that monetary policy in Japan will likely remain accommodative for some time. However, with central banks across the world tightening their monetary policies at an unprecedented rate, Japan’s ultra-easy monetary policy has become increasingly unsustainable.

This has been reinforced by the BOJ’s unexpected decision to adjust its yield curve control policy, a sign that policymakers are warming up to the idea of normalising its monetary policy. While the pace of BOJ’s policy normalisation is still highly uncertain, we see this as the beginning of a policy shift that will favour value investing in Japan once again. As such, the Eastspring Investments - Japan Dynamic AS SGD will allow us to diversify our Japan equity exposure away from growth stocks.

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Portfolio positioning moving forward

To conclude, we reiterate our view (again) that 2023 is shaping up to be yet another challenging year. While we do not expect the demise of SVB as a prelude to the next financial crisis, we expect the troubles in the banking sector to have a negative impact on the economy as banks will likely be more cautious in their lending to guard against the heightened risk of deposit flight. The tightening of credit supply and financial conditions mean that the odds of a recession is now much higher.

There has been rising hopes that the Fed will come to the rescue and cut rates, as they did in the past, with market participants now pricing in at least three rate cuts by year-end. This is not realistic. Financial stability may now be a more important concern for the Fed, but it does not mean the Fed is giving up its inflation fight altogether. With inflation proving to be more persistent than expected, we expect the Fed to press on with tightening, albeit with greater caution to avoid causing serious disruption to the financial system.

All things considered, we believe a defensive portfolio positioning is warranted at this point. At the asset class level, we retain our preference for fixed income over equities, as reflected in our decision to increase our fixed income allocation to Overweight (Table 1).

Table 1: Current inter-asset allocation

Within fixed income, we prefer investment-grade over high yield as a more defensive positioning may be more important in a recessionary environment. As such, we have reduced our exposure to Asian high yield bonds over the month in favour of Asian investment grade bonds (Table 2). In terms of duration, our preference is for short-duration bonds. Given our view that inflation will likely be persistent and the Fed is unlikely to cut rates this year, we expect long-term yields to move up further.

Table 2: Intra-asset allocation for fixed income

Within equities, it is now about finding the least unattractive options (Table 3). Developed markets now look more attractive relative to emerging markets, given our bearish outlook for Chinese equities. Japan remains our top equity market pick. 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.

Table 3: Intra-asset allocation for equities

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.

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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.