Six burning questions from our investors on our portfolio strategy and the market

During our quarterly portfolio webinar and sharing of market views, we received multiple questions

from our clients regarding our portfolio positioning and market views.

Here are six questions we collated that received the greatest interest (and our answers):

1. What is the outlook for US interest rates in 2023 and how does this affect the portfolios?

We expect the Fed funds rate will end the year at a range of 5.00% – 5.25%. While we might be reaching the end of the interest rate hike cycle, we expect the Fed to hold rates at restrictive levels. This is in contrast to the 2-3 rate cuts in 2H23 that markets are currently expecting. We believe the Fed is right. We expect inflation to remain more persistent than expected, leaving policymakers with little room to take their foot off the interest rate pedal.

Chart 1: Markets expect rate cuts to start in 3Q23

The US labour market remains tight, despite initial signs of cooling seen in data initial claims for unemployment. This has kept wages elevated, preventing inflation, particularly the stickier core services, from substantially declining. As a result, prices may moderate but the progress will likely be slow. Recent developments in the oil market have also further complicated things. In our view, the surprise oil supply cuts by OPEC+ have worsened the oil demand-supply mismatch. Many analysts, (including the International Energy Agency) are also expecting a supply deficit in 2H23, suggesting that supply issues have outweighed demand concerns stemming from a potential recession. This means oil prices may find increasing support as we enter 2H23, which is bad news for the trajectory of inflation. Together, these factors make it a daunting task for the Fed to cut rates this year without risking a resurgence in inflation.

Given our view on the interest rate and inflation outlook, we continue to maintain our exposure to value stocks across our MAPS portfolios, which we expect to benefit. For our US (JPMorgan Funds - US Value A (acc) USD), Europe (HGIF - Europe Value PD SGD), and more recently, Japan equity exposure (Eastspring Investments - Japan Dynamic AS SGD), we hold a mix of value and growth funds within these segments, with a larger weight allocated to value funds. While we favour Value stocks, we have not completely discarded Growth stocks. We think it is prudent for investors to remain selective and prefer high-quality Growth names with strong balance sheets and earnings resiliency.

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2. If you expect inflation to remain elevated, what are your views on commodities?

The current macro backdrop is greatly supportive of commodity prices as the asset class is traditionally a good hedge against inflation. When inflation is elevated or rising, this tends to drive significant inflation-hedging flows to the commodities sector which supports prices. Beyond the support from macro drivers, we believe the underlying demand-supply dynamics remain supportive as well.

For oil, the surprise cut to output targets made by OPEC+ of 1.66 million barrels a day has worsened the supply-demand mismatch, putting upward pressure on oil prices. There is not much room for remedy with little supply response from the US in sight and low inventory levels. Therefore, we expect fundamentals to tighten as softer demand (from weaker growth) is countered by supply-side cuts and long-term constraints on production. It is estimated that the global oil market is expected to run short of supply in the second half of the year. The implied deficit in global oil supplies would likely amount to 1 million barrels per day. As such, we expect oil prices to remain elevated.

For metals, prices have recently run ahead after China re-opened and we think fundamentals will need to catch up. Demand remains the key factor in the short term. Broadly, demand may soften as we head into the 2H23 decline in global manufacturing and construction activities. However, metals with large exposure to China’s demand, such as aluminium and copper, may see greater support. On the plus side, inventories in general are still low which can be supportive of prices. The long-term prospects are more attractive, with the ongoing energy transition expected to firmly support fundamentals of green metals (copper, nickel, cobalt, lithium, etc).

For agricultural commodities, prices have declined from the prior year’s peak but remain elevated as compared to history, allowing for strong farm margins to remain. Prices may remain volatile this year, caught in a cross-current of demand and supply factors. Demand, in general, is softening as global growth slows, but China’s reopening has led to a pickup in crop demand. The supply side, however, continues to be faced with challenges such as low inventories for wheat and corn, as reflected by declining stocks-to-use ratios, and adverse weather conditions like El Niño remain a threat.

In our portfolio, the areas most sensitive to changes in commodity prices are our LATAM equity (Schroder ISF Latin American A Acc SGD) and global natural resources exposure (JPMorgan Funds - Global Natural Resources A (acc) USD). Given our view on supportive commodity prices and the positive spillovers to commodity-related companies, we maintain our positioning in these two equity segments.

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3. With the recent release of China’s GDP data, will you reconsider the potential of China stocks?

While China's 4.5% GDP growth came in above consensus estimates of 4%, we remain sceptical about the sustainability of its recovery as many macro uncertainties still lurk in the backdrop.

With decelerating global growth and consequently a weaker external environment, it will be increasingly hard for China to rely on exports as a growth driver. This means that the nation will need to look inwards for domestic drivers. However, domestic data, such as retail sales, imports, and unemployment remain sluggish and suggest that the consumption rebound is far from durable. Furthermore, China’s property sector, a key driver of growth, remains fragile and is unlikely to drive growth significantly this year. In sum, a China recovery is in the works but we question its sustainability and see room for disappointment against consensus expectations.

The near-term economic bounce also does little to comfort us from the worrying longer-term structural issues as China moves towards a top-down state-controlled economy. These include policies prioritising self-sufficiency at the expense of economic growth, and compromising the long-term profitability of private companies that are not aligned with policy direction. Geopolitical risks have also materially increased and are likely to stay as China’s foreign policy stance becomes more assertive.

Given these reasons, we remain unconvinced about Chinese equities. For our portfolios, we have cut our exposure by (1) reducing China equity allocation from overweight to neutral, (2) reducing Asia ex-Japan equity allocation from overweight to neutral, (3) reducing Asian high-yield bonds allocation from neutral to underweight, and (4) cutting allocation to China Tech via the iShares Hang Seng Tech ETF.

For investors who have a high concentration of China-related assets in their portfolios, it may be prudent to gradually reduce China exposure. For investors who still wish to invest in China, we prefer the A-shares market which has a higher concentration of SOEs and companies that operate in industries favoured by policymakers. With A-shares demonstrating greater alignment with the state’s priorities, we expect greater resilience compared to the offshore market.

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4. With Asia equities down year-to-date, what do you suggest investors do?

Despite being down year-to-date, Asia ex-Japan equities have been a hot topic lately after a strong rally since October 2022. That said, we remain cautious for four reasons.

First, we believe the outlook for key markets like China, India, and Hong Kong equities remains challenging (Table 1). For China and Hong Kong, we think the shift in economic regime to a top-down state-controlled model is unfavourable for long-term growth. We also see additional headwinds from increased geopolitical uncertainties with the West and Taiwan.

For India, lofty valuations hurt its upside potential and raise the risk of valuation compression. We also expect further EPS cuts and earnings headwinds. That said, it remains on our watchlist due to attractive structural opportunities. Together, these markets make up nearly 60% of the MSCI Asia ex-Japan index. Without an improvement in the outlook for these key markets, it is tough to turn positive on Asia ex-Japan as a whole.

Table 1: Summarised view of Asian markets under our coverage

Second, Asian equities are no longer cheap and valuations are back around the long-term average. This was driven largely by the rally in equity prices rather than cuts to earnings estimates. At the moment, Asian equities offer little margin of safety in a challenging environment. Lastly, EPS downgrades across Asian equities show no signs of stopping and we expect more cuts to come. Negative operating leverage, where sales growth outpaces earnings growth as a result of rising cost, is signalling potential margin pressure ahead. We believe Asian equities are also in a tight spot fundamentally.

As a reflection of our view, we have reduced our allocation to Asia ex-Japan equities from overweight to neutral across the MAPS portfolios. For investors, we also suggest cutting portfolio exposure to Asian equities if investors are overweight or have a heavy position within their portfolios. For those who want to maintain exposure to Asian equities, we suggest reallocating to ASEAN, a more resilient region within Asia with comparable correlations to major equity indices. Our portfolios have exposure to ASEAN equities via the Principal ASEAN Dynamic Fund Class SGD.

Chart 2: Forward PE ratio for Asia ex-Japan equities have jumped back to long-term average levels

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5. You do not have REIT exposure in MAPS portfolios. Why is that so?

The reason why we do not have an exposure to REITs in the portfolios is twofold. Firstly, our portfolio’s neutral allocation follows a GDP-weight approach, which explains our region/ country level exposure. This excludes REITS from our core equity exposure. Secondly, we excluded REITS from our supplementary equity exposure because of our cautious stance on the sector. Although the majority of REITs’ existing debt is on fixed rates, the companies will eventually be forced to refinance their expiring loans at higher rates, with the rates environment likely staying higher for longer. This will result in a higher average cost of debt, which is a headwind for distributions.

Additionally, capitalisation rates are likely to expand as interest rates remain elevated, and as growth prospects are dampened. As such, we believe property valuations have scope to fall and current valuations provide little margin of safety for investors. The banking crisis has also raised fresh concerns regarding the reverberations of higher interest rates. Even before the Silicon Valley Bank (SVB) saga, there has already been a rise in defaults in the US commercial real estate (CRE) sector. We think tighter financial conditions would suggest that REITs with high leverage (>40%) may have trouble meeting debt obligations.

To achieve higher yields, we recommend allocating to fixed income over REITs . The rapid rise in bond yields globally has provided investors with the opportunity to earn higher yields without taking on the risk associated with equities – REITs in this case. For example, the yield spread between S-REITS and the Singapore 10-year government bond yield is at a multi-year low. The latter can provide investors with decent yields at the cost of minimal risk and low asset volatility. For our portfolios, while there is no REITS exposure at the moment, we do not rule out the possibility to add some if the outlook turn attractive.

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6. What is your view of the Singapore equity market?

Despite the market turbulence last year, Singapore equities were one of Asia’s strongest performers, returning 8.4% in 2022 (SGD terms). Unfortunately, this did not carry over into 2023 as the Straits Times Index had a rough and volatile start in 2023. That said, the factors driving our positive view on the Singapore equity market remain unchanged.

First, we expect local banks to provide resilience to STI earnings. The index has a high concentration of banks (around 50% of the STI), which have benefitted tremendously from an increase in net interest income and net interest margin (NIM) expansions. With our base case that interest rates will stay elevated, we continue to see NIM expansion, albeit with some moderation, which should support banks’ earnings in light of slowing loan growth and higher loan loss provisions.

Second, Asia’s re-opening continues to support domestic growth. We expect the recovery momentum for tourism-exposed sectors to continue, fuelled by China’s recent re-opening. With Chinese tourists forming up the majority of tourism spending pre-Covid, their return could ignite a revival in inbound visitor spending. This can be seen from the recent jump in retail sales data, partly reflecting tourism’s recovery.

Last, we consider the Singapore equity market as a value play, given its cheaper index valuations and high concentration of traditional value sectors (like financials and industrials). We think the natural value-tilt of the index will prove more resilient in the current backdrop where inflation and interest rates are likely to stay elevated for a while.

For our portfolios, we do have Singapore equity exposure via our ASEAN equity fund, the Principal ASEAN Dynamic Fund Class SGD. This fund has around 15% exposure to Singapore equities (one of the larger country exposure), with names like DBS Group and SingTel as some of the fund’s largest holdings.

Chart 3: Earnings forecast and performance of the STI

Table 2: STI upside forecast

Singapore (STI Index)	FY2022	FY2023	FY2024	FY2025
PE ratio (X)	13.1	12.5	11.6	11.2
Projected earnings growth (YoY %)	36.6%	4.0%	7.8%	4.2%
Projected Earnings Per Share (EPS)	248.8	258.7	278.9	290.6
Target fair price (Based on 14.0X Fair PE ratio)	-	-	-	4,070
Potential upside (%)	-	-	-	25.4%
Source: Bloomberg Finance L.P., iFAST estimates. Data as of 9 May 23.

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.

The Research Team is part of iFAST Financial Pte Ltd.

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Six burning questions from our investors on our portfolio strategy and the market

1. What is the outlook for US interest rates in 2023 and how does this affect the portfolios?

Chart 1: Markets expect rate cuts to start in 3Q23

2. If you expect inflation to remain elevated, what are your views on commodities?

3. With the recent release of China’s GDP data, will you reconsider the potential of China stocks?

4. With Asia equities down year-to-date, what do you suggest investors do?

Table 1: Summarised view of Asian markets under our coverage

Chart 2: Forward PE ratio for Asia ex-Japan equities have jumped back to long-term average levels

5. You do not have REIT exposure in MAPS portfolios. Why is that so?

6. What is your view of the Singapore equity market?

Chart 3: Earnings forecast and performance of the STI

Table 2: STI upside forecast

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