Overweight China, US and Japan equities; diversify into gold and commodities: DBS

While higher interest rates are expected to negatively affect the earnings of most companies, banks stand to gain from a potentially big­ger earnings margin as they lend at higher rates.

Many investors have chosen to liq­uidate their holdings and hold on to cold hard cash instead. However, with inflation eating away at purchasing power, holding cash may not be the most viable strategy either.

The question then is: When will the Fed stop? DBS Chief Investment Officer Hou Wey Fook is of the view that it will be sooner rather than later. He believes that the forecasted rate hikes will be sufficient enough to bring inflation under control.

Hou, speaking at the bank’s 3Q2022 investment outlook conference, points out that in the history of peak Feder­al funds rates, the highs of each cy­cle were actually lower than the pre­vious ones as US debt to GDP rose. (see Chart 1).

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Over the past four decades, US debt to GDP has increased from 30% of GDP in 1980 to 130% currently.

“Therefore, it is not surprising there will be a threat to growth from the increasing burden of servicing that huge debt,” Hou says.

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He points out that after just three hikes, the previously vibrant US mar­ket has started showing signs of stall­ing. Retail sales and consumer confi­dence have fallen too. “We, therefore, do not expect rates to go much high­er than what is really priced in, as elevated rates and bond yields are going to quickly slow growth down and therefore slow inflation forward.”

Positioning by investors

Hou believes that investment-grade bonds rated BBB or A are now an “attractive alternative” to owning cash deposits. S-REITs, for their re­liable income-generating quality, are also favoured.

DBS says that good-quality cred­it is now “attractively priced”, with global yields for investment-grade bonds at about 4.4%. These attrac­tive yields are expected to beat cash returns even with rising rates. (See Chart 2).

Within the sector, DBS says the “sweet spot” is in short-dated bonds of between three and five years. Based on cumulative returns since 2003, in­vestment-grade bonds with this ten­ure have displayed a stellar track re­cord in rising above inflation.

Furthermore, should the Fed moderate rate hikes, short-dated, high-quality credit will avail inves­tors of potential capital gains. “We view this risk-reward as advanta­geous for investors to switch from cash to short-dated, high-quality credit — capitalising on the certain­ty of income generation while most other risk assets grapple with vola­tility,” says DBS.

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He also thinks that investors should go and seek out value and quali­ty plays within the equity market, saying that when bond yields start­ed their upward trajectory in 2021, profitable big tech companies stayed resilient, while loss-making emerg­ing tech companies, lost some 70% of their value.

He quotes veteran investor War­ren Buffet, who said that “only when the tide goes out, will you see who’s been swimming naked”.

“So even when interest rates or bond yields are peaked out, I ex­pect profitable tech companies to lead the way.”

Equities and the case for China

DBS is also recommending investors to overweight the equities of Chi­na, Japan, and the US, but under­weight Europe.

The Chinese tech sector, which was what Hou calls “the darling of investors”, has lost about half of its value since the start of 2021. Howev­er, recent events have inspired DBS to turn bullish. Hou says there’s a “line in the sand” drawn by Vice-Premier Liu He when he stated China’s com­mitment to supporting growth and business regulation.

Hou’s investment case for China can be distilled into “3Cs”, name­ly, “cheap, clarity, and catalysts.” First, the Chinese market continues to trade at a significant 37% discount to global equities on a forward P/E basis, which represents great value for investors. “But as we all know in financial markets, cheap [valua­tions] can stay cheap, or cheaper, if there remains an overhang of policy uncertainties,” he explains.

This does not seem to be the case with China, as DBS sees signs of eas­ing in China’s tech crackdown, with China encouraging more homegrown tech listings to reduce the over-con­centration of power in China’s Big Tech. In short, the clarity investors long for is emerging.

Lastly, a catalyst for the Chinese economy comes in the form of poli­cy support. Chinese regulators have suggested an allocation of US$2.4 trillion ($3.37 trillion) to public ex­penditure in 2022 in their bid to re­vive the economy, and domestic cor­porate earnings growth is expected to rebound to the mid-teens in 2023.

Over in Japan, DBS has upgraded their rating to overweight and looks to gain exposure to Japan’s “Sumo­toris” or heavyweight companies with durable competitive advantag­es globally.

From a macro view, the Kishida government is expected to launch additional stimuli to strengthen do­mestic sentiment before the upper house elections.

This is on top of a record annual budget passed in March and an ad­ditional stimulus package unveiled in April to cushion the impact of ris­ing oil and food prices on the public.

Furthermore, in contrast to mon­etary tightening in most developed economies, the Bank of Japan is ex­pected to maintain the existing yield curve control policy framework to keep the economy buoyant. As such, the yen’s resultant weakening provides further tailwinds for the earnings of Japanese exporters and greater val­ue for foreign investors.

As for US equities, Hou continues to advocate for exposure to quality plays, especially Big Tech companies in the S&P500. For the most part, US Big Tech is backed by robust earn­ings, and rising bond yields have a limited impact on the long-term fun­damentals of this space, DBS says.

Economic moats for these big tech companies like a strong network ef­fect, high switching costs, and rich intangible assets will continue to en­sure resilient earnings.

For those worried about the recent selloff, DBS points out that histori­cal data suggests that this was driv­en predominantly by the recalibra­tion of investors’ expectations, and valuations are now becoming more attractive.

Satellite play

However, for the sake of diversifica­tion, Hou says investors should fit gold and commodities as a “satel­lite play” in their portfolio.

In this inflation cycle, Hou says that the usual safe-haven assets when risks heightened, like US government bonds and high-grade bonds, have fallen (see Chart 3). Even cryptocur­rency, with Bitcoin as an example, has fallen about 55% year to date.

“The only asset class that held up was gold,” Hou points out, with DBS saying that gold will be a stag­flation hedge, putting a target price of US$2,200 by the end of the year.

The bank writes: “Our target price is supported by our views that the dollar has traded past its peak in 2Q2022; and the Russia-Ukraine con­flict could drag, driving demand for gold as a portfolio hedge.”

For commodities, Hou highlights fossil fuels, soft commodities and met­als as some areas that investors can look at. This is because global frag­mentation will continue to drive up price risks, and geopolitical tensions and supply-side disruptions are con­tributing to increasing protectionism.

For example, countries are limit­ing the export of food, energy, and other staples to justify “self-suffi­ciency”. This could lead to the un­predictability of supply chains and rising prices.

Separately, even though political pressures have called for a shift away from fossil fuels, Hou says they still make up the bulk of energy genera­tion as renewables have yet to provide a feasible alternative. Even when the transition to low-carbon infrastruc­ture happens, the transition will be “metals-intensive”.

This demand boom, coupled with prohibitive regulations and chronic underinvestment in metals produc­tion due to ESG concerns, is set to see tightening demand-supply dy­namics in this area.

Overall, Hou sums up the in­vestment case by saying “growing wealth cannot be hurried. Unlike short-term opportunistic trading or positions which investors often get excited over, there certainly appears to be a place to invest a larger por­tion of one’s surplus wealth over the long term”.