At the start of the year, we said that global capital markets are at a crossroads. And things could go either way. Five months in, there appears to be little improvement in terms of clarity on the macroeconomic outlook. Indeed, if anything, it is cloudier and investor positionings — both the bearish and bullish — may have become even more divisive and entrenched. It does seem that many are now investing based on convictions rather than on facts and evidence — oftentimes, the same set of data can be interpreted in such a way as to support their own contrasting expectations.
The closest to a consensus right now, we think, is that the current interest rate-hike cycle is nearing the end. The US Federal Reserve has reduced the quantum of its hikes to 25 basis points this year, from 75-basis-point increases (four times from June to November 2022). And its indicative terminal range (5% to 5.25%) suggests just one more 25-basis-point increase for the rest of this year. Other central banks, including in South Korea, Australia, Indonesia, India, Singapore and Malaysia, have stopped monetary policy tightening for now.
What happens next, though, remains a subject of heated debate and contradictions, specifically with inflation and economic growth. It does not help that the slew of economic data has been decidedly mixed, adding to the confusion.
Stocks and bond markets differ on imminence of recession
The bond market, which has been signalling recession for many months — with the steep yield curve inversion for US Treasuries, which has, historically, been a pretty accurate predictor of recession — may just be screaming one now. It has gone from expecting higher inflation and interest rates to predicting rate cuts — of at least 0.5% to 0.75% — before the year is over, predicated on expectations of rapidly deteriorating economic conditions and a drop in inflation. Yields have fallen sharply across all durations, underscoring the change in their forward inflation expectations. The two-year Treasury yield, seen to be most reflective of Fed actions, has fallen by almost a full percentage point, from around 5.1% to 4.2% (at the point of writing; see Chart 1).
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Stocks, on the other hand, have continued to inch higher. High-growth, tech stocks that are most sensitive to interest rates have outperformed with the Nasdaq Composite up 15.3% year to date, compared to the 7.7% gain for the S&P 500 Index. This is consistent with bond market expectations that the interest rate is near peak — but earnings forecasts and share prices do not reflect imminent recession.
According to data provider FactSet, earnings are expected to grow 0.8% in 2023 and 12% (on the back of higher margins) in 2024. Critically, prevailing valuations are not pricing in the risks for potential earnings shortfall. Forward PE for the S&P 500 stands at 18.2 times, higher than the 10-year average of 17.3 times. Meanwhile, the stock market measure of “fear” — the CBOE Volatility Index (VIX) — has fallen to the lowest level in over a year (see Chart 2).
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In short, none of these stock market measures suggest the pessimism and uncertainties that are typical of recession. They may mention it and the headlines say it, but actions in the stock market suggest that investors are bullish on the economy. It implies expectations that inflation and interest rates will drop quickly, without inflicting widespread damage.
What is even more remarkable is that the US equity market is pricing in three interest rate cuts before the end of this year. Not even a soft landing, but a “no landing” by the Fed in reining in inflation and excess liquidity. There is even a newish economics term for this “miracle” narrative — immaculate disinflation.
And gold is saying something else …
Interestingly, gold has also done very well so far this year, with prices nearing all-time record-high levels and up by as much as 25% from November 2022. Clearly, the gold market also believes that interest rate has peaked — given that a higher interest rate would raise the opportunity cost for holding gold and dampen demand.
Gold is traditionally seen as an inflation hedge and safe-haven asset during times of increased economic and geopolitical uncertainties. Does the current price rally mean that gold investors, contrary to stock and bond investors, expect the inflationary environment to persist, which would then prevent central banks from cutting interest rates in a recession, thereby worsening the downturn?
Granted, central banks — led by China, Russia and emerging countries — have been a major source of gold demand. They collectively bought a record amount of gold last year, based on data going back to 1950. And they may have different considerations — aside from expectations of persistent inflation and economic uncertainties. It could also reflect increasing diversification away from US Treasuries and dedollarisation, what with the US’ weaponisation of the greenback in the Russia-Ukraine war.
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But everybody cannot be correct at the same time
Clearly, everyone cannot be right at the same time — not with such contradictory expectations. Bond traders are, by conventional wisdom, the “smarter money”. The global bond market is far larger in terms of volume and value traded than stock markets. It is also the more “boring” market — with lower volatility — where trades are driven by analyses of economic and financial data performed by statisticians, economists and such. Participants are mostly global, longer-term institutional investors such as retirement and pension funds, insurance companies and financial institutions.
By comparison, stock markets have a higher percentage of active retail-individual investors, especially in recent years, thanks to improved accessibility and ease of trading via smartphone apps as well as fractional share trading and zero commissions. Their decisions are, oftentimes, driven by emotion and sentiment — such as FOMO (fear of missing out) — and tend to have a greater element of speculation. Also, stock investors — and analysts — are generally optimists by nature, we believe. They have to believe that companies will do better in the future or they would not be buying stocks at all, whether for dividends or capital gains.
We stand by our previous convictions
So, who is wrong? Only time will tell. Where do we stand in this debate? Well, like so many investors, we too are doubling down on our convictions, which we have laid out in previous articles.
Yes, inflation has fallen from the high of 9.1% in June 2022 to 5% in the latest reading for March 2023. This is the low-hanging fruit — and math. The year-on-year rate of increase should drop due to the higher base effect. If it does not, then we would be in deep, deep trouble. The problem is getting inflation from 5% back to 2%.
The last time inflation in the US declined from 5% to below 2% was the period from 1990 up until the Covid-19 pandemic — driven, to a large extent, by the golden age of globalisation. Deng Xiaoping kick-started China’s economic reforms and open-door policy in 1978, culminating in the country’s accession to the World Trade Organization in 2001. The huge influx of cheap labour, first from China and later from other emerging countries, led to the secular decline in prices and inflation globally. The last three decades, after the end of the Cold War, was also a period of relative political stability, unprecedented cooperation between nations and economic integration. Unfortunately, the world is a very different place today.
Fallout from the pandemic, worsening geopolitical tensions between the US and China, and Russia’s invasion of Ukraine have sent globalisation into reverse. Protectionism and trade barriers are rising around the globe — usually in the name of economic and national security — as countries turn their focus inwards towards self-sufficiency, supply chain resilience, reshoring and friendshoring. The costs of ongoing trade fragmentation, shifting supply chains, friction in capital flows and technology decoupling will start adding up to higher inflation and slower growth.
Production based on competitive advantage and trade leads to the most cost-efficient global supply chain, resulting in cheaper and cheaper prices. Deglobalisation, on the other hand, translates into increased cost inefficiencies and lower productivity, at least for the foreseeable future. For instance, wages in the US are far higher than those in China and emerging countries — and rising. The job market, while moderating somewhat, is still strong. The US unemployment rate remains near historical lows and based on the latest count, there are 1.7 job openings for every unemployed worker.
Prices for many key commodities, including food, energy and fertiliser, remain troublingly high — above pre-pandemic levels, though off recent peaks — feeding inflationary pressures (see Chart 4).
In short, we think inflation will be stickier than both stock and bond markets currently expect and while the interest rate may be near peak, it will remain higher for longer — thus increasing the probability of a global recession. Bear in mind that even as inflation (the rate of price increase) is falling, absolute prices are not. Rising cost of living is an emerging crisis for a huge swath of the world’s population, which will weigh on consumption and growth. For instance, the price for rice, a staple food for Asia, is trading near the highest levels in four decades. Rising debt servicing costs, too, will pressure government finances and its ability to spend in the event of recession, given already high public debt levels.
We think this rise in cost of living, leading to anger over income inequalities, may boil over, resulting in mass strikes and political upheavals in democratic societies — adding to more “black swan” events.
So far, the impact of monetary tightening by the Fed and other central banks has been buffered by the Bank of Japan (BoJ), which is adding liquidity to global financial markets as it defends its yield curve control programme. Its extreme policies — more than two decades of negative interest rate, quantitative easing and yield curve control — have created huge distortions in the domestic stocks-bond markets. It kept alive zombie companies and sapped productivity growth — with not much to show for in terms of stimulating inflation, wages, investments and economic growth. (The recent spike in inflation was due to external supply factors, including higher food and energy prices.) With a new governor in place, the time may be ripe for the BoJ to start normalising its monetary policy.
Over the years, Japanese investors have become huge holders of foreign assets, including US Treasuries, in their search for returns. If and when they start moving money back to Japan, there may well be additional upward pressure on global yields. We doubt the BoJ will make any sudden and major policy change, but even slow and gradual shifts will have spillover effects on the rest of the world, potentially triggering more volatility in markets.
If the Fed does blink, and cuts the interest rate prematurely, it risks a repeat of what happened in the 1970s — resurgence in inflation. This would eventually lead to the worst-case scenario — stagflation. In this environment, corporate earnings will be battered by the simultaneous fall in sales and rise in costs, resulting in squeezed margins, and ultimately, layoffs that will raise unemployment and worsen the economic pain. Tesla’s shrinking margins and sharp profit decline — following rounds of price cuts to stimulate demand amid rising production costs — may simply be a precursor of worse to come. Any of the above events puts US stocks at greater risk, given their relatively high valuations. Hence, our continued avoidance of this market, for now. And it is for this reason our Global Portfolio has underperformed. The portfolio currently consists mainly of China-based stocks and selective, opportunistic acquisitions such as the two deep-value Malaysian stocks, Star Media Group and Insas. We discussed deep-value stocks in our article last week (“Why do some companies trade at below net cash? Opportunity or value trap?”, April 24).
China will turn to domestic consumption to drive growth
We think China’s economic growth will be comparatively stronger, bolstered by its recent reopening from pandemic lockdowns. Plus, Chinese stocks are trading at more attractive valuations compared with their US peers (see Table).
The global economic (exports) slowdown, coupled with geopolitical tensions with the US and its Western allies, we believe, will push China to lean heavily on domestic consumption to drive its economy. And, unlike US consumers, Chinese domestic consumption will be supported by local manufacturers and service providers; meaning to say, there will be little spillover gains for the world.
This reliance on domestic consumption to drive investments in the domestic supply chain makes perfect sense for the Chinese government. For starters, reducing dependence on exports — the US is the world’s largest consumer market but is proving to be less reliable with rising geopolitical tensions — will also reduce its longer-term exposure to the US dollar. More importantly, the country can leverage its huge domestic market to drive innovation.
Large, demanding and even critical consumers are important catalysts in creating enduring competitive advantages in companies that will then serve them well in the global market. Robust domestic rivalry forces companies to constantly innovate and upgrade — better technology and way of doing things, more efficient production process, new product design or market, more effective marketing approach and so on — to thrive or die. Case in point: The Chinese government’s focus on investments in infrastructure and incentives for strategic sectors like 5G and renewables has spurred high adoption rates and innovation, which in turn created world leaders the likes of Huawei, BYD and CATL.
Promoting stronger integration between domestic companies will further broaden and deepen the country’s existing ecosystems, reducing the risk of dependence on foreign suppliers and technology, which has been shown to be vulnerable to pressures from geopolitics. This is especially so with the US intent on kneecapping its progress in advanced technologies — to the extent of removing the country from the global supply chain, of which it is currently integral. In other words, we think China’s economy will be increasingly self-sufficient over time. This is the basis of our big bet on Chinese domestic-centric companies.
The Global Portfolio was up 2.2% for the week ended April 26. Strong gains from Star Media Group (+19.9%) as well as positive performances from BYD Co (+1.4%) and Insas (+0.6%) offset broad weakness in Chinese stocks. Alibaba Group Holding (-12.1%), LONGi Green Energy Technology Co (-10.1%) and Global X China EV and Battery ETF (-6.6%) were the biggest losers last week. Chinese tech stocks, in particular, suffered another round of selloff on growing geopolitical risks. Last week’s gains lifted total portfolio returns since inception to 37.2%, trailing the MSCI World Net Return Index’s 44.7% returns over the same period.
Meanwhile, the Malaysian Portfolio gained 9.5% last week, far outperforming the benchmark FBM KLCI, which fell 1.3%. All four investments in the portfolio ended higher for the week, led by Star Media Group (+20.6%) and KUB Malaysia (+15.5%). Total portfolio returns now stand at 194.7% since inception. This portfolio is outperforming the benchmark index, which is down 22.7%, 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.
