Positioning our portfolios for the opportunities to come in 2024

• Given our more positive outlook on the global economy and expectation of a rolling recession instead of a broad-based recession, we have increased our equity exposure by 2.5% (from underweight to neutral).

• As we turn more positive on equities, we have also made use of this opportunity to equal weight our value and growth allocations for US, Europe, and Japan.

• For fixed income, we raised our exposure to emerging market bonds by 2.5%, bringing it from underweight to neutral. Emerging market bonds continue to offer attractive yields while credit risk remains manageable.

• To fund the increase in emerging market bonds, we further underweighted Asian high yield bonds by -2.5%. Unappealing valuations and elevated risk level associated with China’s deteriorating property market and economic slowdown are key reasons for reducing our exposure to this sector. 

2023 has been an eventful year for financial markets. 

From the sudden collapse of several US banking institutions to rising tensions in the Middle East, wild swings in bond markets to an AI powered rally, there was more than enough going on to keep investors on their toes. But despite the high level of market volatility, both equities and fixed income ended the year on a strong note, reversing the heavy losses they endured in 2022 (Figure 1). 

Figure 1: Both equities and fixed income ended the year in positive territory 

Although we believe that the worst is behind us and 2024 is shaping up to be a better year for the global economy, it still pays to be cautious while selectively increasing exposure to markets and sectors we find attractive.

To kick start the new year, we have made three major changes to our MAPS portfolios, summarised in Table 1 below. In this article, we will share in greater detail what these changes are, and the rationale behind each of them.

Table 1: List of changes we made to our portfolios in January 2024  

1. Raised equity allocation from underweight to neutral

The first change that we implemented was to raise our equity allocation by 2.5% from underweight to neutral in exchange for reducing our fixed income exposure by the same amount (from overweight to neutral). This effectively brings the inter-asset allocation across all portfolios back to their neutral allocation.

Prior to this change, all our portfolios (except the conservative ones) had a 2.5% overweight for fixed income. This was implemented back in March 2023 when the Fed was still locked in a fierce battle with inflation. Back then inflation (measured by the consumer price index) was still at 6%, prompting Fed Chair Jerome Powell to repeatedly call for more rate hikes, and for policy rates to be kept higher for longer. Economic growth was also much weaker compared to the present and fears of a broad-based recession was rife.

Fast forward to today, the US economy is on a stronger footing than before, proving that it can still deliver growth even as interest rates remain elevated. According to advance estimates published by the Bureau of Economic Analysis, real GDP increased at an annual rate of 3.3% in 4Q23, easily beating the consensus forecast of a 2% gain (Figure 2).

Figure 2: The US economy remains resilient even in the face of higher policy rates

Majority of the gains were driven by consumption, as consumer confidence recently hit fresh two-year highs on the back of favourable labour market conditions and growing expectations of a soft landing. And with most consumer debt (primarily mortgage) tied to fixed rate loans, consumers have become less sensitive to changes in interest rates compared to the past and their balance sheets have remained pretty robust thus far.

Aside from the consumer, the health of corporate America is also better than expected as many companies took advantage of the pandemic to refinance their debt at lower rates and for longer durations – resulting in less refinancing needs in the near-term. Most of the corporate debt in the US also carries an investment grade rating, which means that the increase in interest expense should not be significant even with higher interest rates.

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Brighter prospects for the US economy in the road ahead

Turning more positive on equities: A pickup in corporate earnings to propel share prices higher  

As the US economy continues to surprise on the upside by delivering better than expected economic data, the likelihood of a broad-based recession is diminishing. Instead, we believe that it is in a rolling recession, where different parts of the economy take their turns contracting. Case in point are the digital economy and semiconductor sectors which have already experienced a downturn over the past two years marked by several quarters of negative earnings growth and a surge in layoffs (Figure 3).

Going forward, we expect to see a pickup in corporate earnings led by companies within these sectors, which should be supportive of equity prices - thus giving us more room to raise our equity exposure. 

Figure 3: Digital economy and semiconductor companies to lead the earnings recovery

2. Equal weight value and growth allocations

As we turn more positive on equities, we have also made use of this opportunity to equal weight our value and growth allocations. Prior to this change, our US, Europe and Japan equity exposure had a 70% allocation to value funds and 30% allocation to growth funds. 

With the global economy on a stronger footing than before and the risk of a broad-based recession diminishing, we see room for growth stocks to continue their outperformance. Going forward, our focus will be on high quality growth stocks that exhibit characteristics such as robust earnings growth, strong balance sheets and durable long-term profitability. Companies that possess unique competitive advantages such as pricing power and network effects will be a plus. We believe that such companies will thrive regardless of economic conditions, making them a staple in investors’ portfolios. 

With regards to value, given our base case for inflation and interest rates to stay higher for longer this year (exemplified by January’s hotter than expected CPI print), we see merit in retaining some value exposure across our portfolios, especially if inflation continues to surprise to the upside or if yields move higher. 

3. Raised emerging market bonds from underweight to neutral, further underweight Asian high yield bonds 

Lastly, for our fixed income intra-asset allocation, we have raised our exposure to emerging market bonds by 2.5%, bringing it from underweight to neutral. Despite all the ups and downs of the bond market, emerging market hard currency bonds continue to offer attractive yields relative to history (Figure 4), while credit risk remains manageable.

Furthermore, on a relative basis, emerging market hard currency bonds also offer a generous pickup over other major bond segments, for instance US treasury bills of similar duration (+315 bps), Asia investment grade bonds (+200 bps) and global investment grade bonds (+360 bps). 

Figure 4: Emerging market bonds offer attractive yields for investors

In exchange for increasing our emerging market bond exposure, we have further underweighted Asian high yield bonds (-2.5%) given our negative view on China’s economy. While most major equity markets managed to deliver positive returns in 2023, Chinese equities bucked the trend as the MSCI China Index plunged by more than -12%. 

The lackluster performance of Chinese equities should not come as a surprise to investors as the reopening rebound has largely faded. The world’s second largest economy is facing plenty of headwinds, such as waning investor confidence, deflation and an ailing property sector. 

Even though the government has pledged greater support for the property market multiple times throughout the year, confidence in China’s real estate market continues to sink as investors are quickly losing faith. The recent news of Evergrande’s forced liquidation is only a sign that the country’s real estate troubles are far from over. 

Besides the negative outlook on China, valuations for Asian high yield bonds are also unattractive. Since December 2022, spreads have tightened by more than 900 bps and are currently near their historical average (Figure 5). Such tight spreads severely limit the room for further compression and diminish the upside potential for bond prices. 

Figure 5: Spreads for Asian high yield bonds have tightened significantly

Given the high level of uncertainty surrounding China’s economy, markets are far too optimistic and may have over discounted the risks associated with its deteriorating property market and economic slowdown. On balance, we feel that the risk to reward ratio for Asian high yield bonds is skewed to the downside and thus it would be prudent for us to reduce our exposure to this sector for the time being. 

Table 2: Current inter-asset allocation

Table 3: Intra-asset allocation for equities

Table 4: Intra-asset allocation for fixed income

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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.