A marginally better-than-anticipated October inflation report, on the heels of a slew of weaker-than-expected economic data, fuelled market bets that not only have US interest rates peaked, but also that the Federal Reserve will start cutting in 2024, as early as at its March or May meeting. And that will help the economy avoid recession. In short, the market is all-in on the soft landing scenario. This, in turn, fed the stock and bond market rallies.
Last week, we discussed why we think the current optimism for stocks is unsustainable — earnings uncertainties remain heightened, and the risk-reward proposition is unattractive at prevailing historically expensive valuations. Yes, a quick Fed pivot will limit the damage of high interest rates on the economy and corporate earnings. But we also explained why we think such expectations — for an early and sharp cuts in interest rates (consensus now expects a cumulative 100-basis-point reduction by end-2024) — may not be realistic.
Inflation may well continue to moderate, but the move towards the Fed’s 2% target will be much stickier from hereon. This is due, in part, to the large component of services in the US economy — where workers are regaining bargaining power. Wages, while off the recent highs, are still growing faster than they have in two decades (see Chart 1). We believe inflation and, therefore, interest rates are unlikely to return to pre-pandemic lows anytime soon.
Higher-for-longer borrowing costs will hurt businesses and households, raising credit risks and the probability of recession in the US. Historically, corporate earnings contract during recessions, as weaker demand (sales) eats into margins and profits.
At the early stages of recession, bonds — with fixed future cash flows — tend to outperform stocks. This is the reason why we think bonds will regain attractiveness over the coming months. In fact, the bond market has already been seeing increasing fund inflows in recent weeks.
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As a result, yields (which are inversely correlated to prices) have fallen sharply, after briefly breaking above 5% in October, the highest level in 16 years (since the global financial crisis). See Chart 2. (The drop from 5% to the current 4.5% generated a 10% capital gain.)
The bond market has been particularly volatile this year, from a historical perspective, on the back of rapid reversals in market expectations. The Fed could still raise interest rates, depending on how the upcoming economic data looks like, in which case yields could reverse higher (and prices lower), again. That said, we do think the downside risks for bonds are likely limited from hereon. Interest rates are near, if not at, peak.
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The benchmark 10-year US Treasury yields are likely to stabilise around 4% to 5% for the foreseeable future, while inflation should gradually moderate. This means that for the first time in a very long time, investors can now earn stable (predictable) real income returns (after adjusting for inflation) on low-risk bonds. Real yields on the 10-year US Treasury have risen well above 2% currently. This is a sharp reversal of the years since the GFC, where falling interest rates meant that large segments of savers were forced to invest in riskier assets in the search for yields.
There are plenty of options in the US bond market. Retail investors can easily invest in long-dated US Treasuries through low-cost exchange traded funds (ETFs), the largest and most liquid of which is the iShares 20+ Year Treasury Bond ETF (TLT). For slightly higher yields, investors can go for corporate bonds. Table 1 lists some other ETFs for investment-grade corporate bonds. One can also buy high-grade individual bonds issued by big caps such as Apple, Microsoft and Alphabet through a broker, including discount brokers like Charles Schwab Corp or ETrade.
While lower-rated bonds offer even higher yields, they also come with higher risks — as we explained in our article last week, higher-for-longer interest rates will raise credit risks. Therefore, one must take this into account. Remember, what matters is the risk-adjusted returns — investing is not just about maximising returns but also managing the risks.
Of course, investing in US bonds comes with currency risks. For instance, the US dollar could weaken as interest rate differentials with the rest of the world narrow when the Fed starts cutting. As such, one might prefer bonds denominated in other currencies — the decision depends on your outlook on the currencies.
Table 2 shows the prevailing nominal and real yields on 10-year government and investment-grade corporate bonds in the US, Malaysia, Singapore and China. Currency movements are notoriously difficult to forecast. We would not attempt to do so here. And real yield comparisons depend on the inflation rate, which may or may not reflect real-world price increases. Inflation will affect currency values.
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For Malaysians and Singaporeans who prefer to invest in their local currencies, there are options, though more limited. There are two sovereign bond ETFs that are traded on the Bursa Malaysia and Singapore Exchange S68 (see Table 1), but liquidity is comparatively low.
One could also buy SGS bonds, Savings Bonds and T-bills that are regularly issued by the government of Singapore in the primary auction market via the three domestic banks (DBS, OCBC and UOB). You can check out the issuance calendar and other details here: https://www.mas.gov.sg/bonds-and-bills.
On the other hand, retail investors in Malaysia have no direct access to government-issued bonds (such as Malaysian Government Securities, MGS) and Malaysian corporate bonds. These are sold through primary market auctions and private placements to banks, institutional and high-net-worth investors. While some MGS and corporate issues are available in the secondary market, the latter usually requires minimum investments of RM50,000, RM250,000 or RM1 million.
There are a handful of individual corporate bonds listed on the Singapore Exchange and one exchange-traded bond currently listed on Bursa (issued by DanaInfra Nasional Bhd). Bear in mind though, most have very low vol- umes, and indeed, see no trading on most days.
Therefore, in practical terms, the only bond options available to retail investors are through unit trusts. Unfortunately, online investment platforms and unit trusts often charge relatively high fees (upfront and recurring quarterly-annual fees) that depress overall returns.
While the lack of domestic investment options for bonds may be disappointing, our view is that it is probably irrelevant at this point in time. If you are like us, experiencing broad price increases of more than the 1.9% official inflation in Malaysia, then real yields for Malaysian bonds are too low anyway — observe that Singapore inflation is at 4.1% with a stronger currency — and you might as well deposit your funds in foreign currency accounts where interest rates are even higher. (See our article “Right to leave domestic interest rates unchanged but ringgit will weaken” published on Sept 18, 2023). Our preferences currently are US dollar and Singapore dollar government bonds or very high investment-grade corporate bonds. Risk taking in the current investment climate does not pay.
Next week, we will share some of our specific investment ideas (bonds, ETFs and stocks). We know many of our readers have limited use for policy articles, economics and broad market analyses.
The Malaysian Portfolio ended marginally lower for the week ended Nov 22, lesser than the benchmark FBM KLCI’s 0.7% loss, thanks to our high cash holding. Shares for Insas fell 0.6% for the week. Last week’s losses pared total portfolio returns to 158.8% since inception. This portfolio is outperforming the benchmark FBM KLCI, which is down 20.4%, by a long, long way.
Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/ or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.
