DBS CIO likes European equities for strong recovery; stays positive on S-REITs

The report, titled Hope into Reality, reflects the bank’s optimism. But while investor sentiment has been buoyed by accelerating vaccination rates, a different set of concerns now appears on the horizon. In particular, Hou notes that inflation fears have become more pronounced, especially as commodity prices have bounced back. In addition, the dovish policies set by central banks last year to counter the onslaught of the pandemic are starting to normalise, with the Bank of Canada and the Bank of England among the first to start tapering bond purchases.

As speculation mounts on when the US Federal Reserve will start reducing its pace of asset purchases, investors are questioning whether markets, some of which have rallied to all-time highs in the last few months, are about to see major corrections.

Hou thinks not. “[There] are indeed pockets of bubbles, but it is not a broad-based, systemic bubble,” he remarked at a market outlook briefing following the release of the report on June 28.

Taper but no tantrums

The Fed currently purchases some US$120 billion ($161.2 billion) in US Treasuries and mortgage-backed securities on a monthly basis, providing stability to the markets.

While the US central bank stuck to its guns at the June Federal Reserve Open Market Committee (FOMC) meeting, keeping policies unchanged, investors are growing fidgety over “taper talk” and its potential impact on the market in the second half of the year.

Hou concedes that concerns over monetary tightening will “dominate the narratives” in the coming months, giving rise to high market volatility. He also views that a Fed tapering this year cannot be ruled out, in the event that inflation expectations, which stand at 2.4% as of May, approaches the 3% mark.

Nonetheless, he believes that a repeat of a “taper tantrum” is improbable. “[Unlike] in 2013, we believe there will be tapering but no tantrums,” he says.

He argues that the Fed, armed with lessons from what happened before, will be measured in withdrawing its monetary stimulus while providing clear reassurances to the market that interest rates will remain zero-bound as it continues to take a relaxed stance on inflation.

Hou echoes the Fed’s views on inflation, believing that the current elevated inflation figures — US core inflation stood at 3.8% in May — are transitory and will gravitate back towards lower levels in the long run due to ageing demographics and the shift towards digitalisation, which should provide deflationary pressure.

In any case, he points out that any Fed taper coming off the back of a recovering economy is “not negative” for equities, as better corporate earnings will support the market. As highlighted in the report, global equities actually gained 8% during the period between the start of the taper tantrum up until the first rate hike by the Fed in December 2015, albeit with a vast divergence between developed and emerging markets.

While developed market equities gained 13% over the period, emerging market equities fell 24%. DBS expects this trend to repeat if and when the Fed starts tapering.

Nonetheless, Hou remains confident in the asset class as a whole. “[We] do not think [tapering is] a risk to the equity market, provided the Fed is able to be ahead of the curve and tighten or taper off preemptively,” he concludes.

Barbell portfolio

Given the macroeconomic environment, DBS maintains its preference for equities over bonds for the 3Q2021, given that the vaccination roll-out and global recovery will drive the performance of the equity market.

However, the bank views that the macro rebound for the US, Japan, and Asia ex-Japan has peaked for now, with some moderation expected in the coming months. On the flip side, growth momentum for Europe “appears promising” given its success on the vaccination front.

To that end, DBS is overweight on European equities. As the report states: “The economic surprise numbers from Europe are now coming in better than US/Japan combined and underlines the momentum in the region’s recovery.” Meanwhile, it has downgraded Asia ex-Japan equities to neutral due to its deteriorating Covid-19 situation, given how the region accounts for almost half of new infections this year so far.

The report also states a preference for developed markets over emerging markets, in view of Fed tightening concerns. The region’s huge dependence on external and dollar funding is especially vulnerable to rising US Treasury yields, while the slower roll-out of vaccines has seen more frequent spikes in new Covid-19 cases.

Notwithstanding the changes in DBS’s asset allocations, Hou continues to advocate a “barbell” approach to investments in which investors take predominant exposures to income-generating assets as well as secular growth stocks.

For income, Hou prefers five-year BBB/BB-rated bonds and dividend-yielding equities, particularly China banks and Singapore REITs (S-REITs), as well as hybrid capital instruments including Additional Tier 1 (AT1) bonds from European and Asian banks and Restricted Tier 1 (RT1) instruments from insurance companies. For investors looking for alternative income sources, Hou suggests covered calls on equity positions can be considered.

For S-REITs in particular, DBS highlights that compared to global REITs, S-REITs offer one of the highest dividend yields at 5% and compelling yield spreads of close to 3.6%. Specifically, the bank prefers S-REITs within industrial sectors including data centres and business parks, as well as suburban retail which has demonstrated resilience throughout the pandemic.

For secular growth stocks, which refers to equities riding on long-term irreversible growth trends, Hou identifies themes including digitalisation, increased millennial spending, and the rising China economy, which he believes will benefit stocks in sectors such as semiconductor and automation.

To round out the portfolio, Hou continues to recommend gold as a way for investors to diversify portfolio risk and maintain resilience against short-term volatility. Gold prices saw a comeback in the 2Q2021 after a weak preceding quarter due to a retreat in US bond yields, a weakening in the US dollar, and a softer employment outlook. “We expect gold prices to remain supported in 3Q2021 and the aforesaid factors should remain favourable to gold,” the report states.

Shifting to electric

For investors looking for a long-term growth play, DBS is also bullish on the shift towards electric vehicles (EVs).

Noting that global EV sales grew 40% in 2020 despite overall car sales falling 14%, DBS believes that EVs are on track to overtake internal combustion engines vehicles (ICEVs) as the automobile of choice in the next century.

Catalysing this will be a fall in production costs underpinned by technological advancements, which should lead to lower pricing. EVs are expected to reach cost parity with ICEVs by the end of the decade, while EV sales are anticipated to account for 58% of new car sales by 2040, compared to 2.7% in 2020. In addition, a shifting regulatory landscape led by governments pushing to decarbonise is expected to provide policy support and stimulus to the industry.

While pureplay EV companies, charging infrastructure providers, and battery and chipset manufacturers are expected to be clear winners from the transformational shift, Hou adds that legacy automakers will also benefit as they struggle to catch up. Pointing out that Tesla is currently valued more than the top four legacy automakers (Toyota Motor Corp, Volkswagen Group, Daimler and General Motors Company) combined, Hou sees potential for a huge uplift to their share prices if the companies can execute a transformation towards EVs successfully.

While the world still makes its way out of the depths of Covid-19, DBS is optimistic that the time is near for investors to see the start of recovery.

Photo: Bloomberg