You would quite likely have read more than a few commentaries on the performance of global equities so far this year, now that 1H2023 is in the rearview mirror. And we bet that one of the most common narratives is how stocks have surprised on the upside; with Wall Street leading the rally, the S&P 500 index and Nasdaq Composite are up 15.9% and 31.7% respectively in the first six months of the year. Indeed, most investors had started the year in bearish mode, following a bruising 2022 when almost all asset classes — including stocks, bonds and cryptocurrencies — suffered massive losses. There were widespread expectations of an imminent global recession, with central banks aggressively hiking interest rates to tame the highest inflation in decades.
In our first article this year, we wrote that markets were at a crossroads — they could go either way (huge gains or huge losses) — and against the backdrop of great uncertainties, there would be increased volatility in asset prices. We were right about the uncertainties — analysts, economists, market commentators and investors remain deeply divided on the economy and the stock market’s near-term direction. Yet, volatility has fallen steadily lower this year, save for the brief spike up during the US regional banking crisis in March, as the market climbed higher (see Chart 1).
Yes, as we pointed out some weeks back (based on data up to May 25), this rally was driven, primarily, by a handful of mega-cap tech stocks while the rest of the market was mostly flattish (see Chart 2). But flattish performance still defied bearish expectations for a broad market decline or, worse, crash. Although the eurozone did fall into a mild recession — a marginal 0.1% contraction in both 4Q2022 and 1Q2023, though it could get worse in the months ahead — the widely anticipated US recession remained elusive.
In fact, the US economy is doing far better than expected — the final revision for 1Q2023 gross domestic product (GDP) came in at 2%, way above initial estimates and market predictions. Currently, the Atlanta Fed’s GDPNow model is forecasting just marginally lower growth for 2Q2023, at 1.9%. The slew of recent data suggests an increasingly upbeat outlook.
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Consumer confidence in June is at the highest since January 2022, up on favourable expectations of the job market and declining inflation. Overall consumer spending has stayed surprisingly robust, despite rising prices and some downtrading, aided by excess pandemic savings. Hiring has remained strong, especially for the lower skill-lower pay jobs, and the unemployment rate is still hovering near record lows. The pandemic has accelerated early retirement, especially among ageing baby boomers, resulting in a falling labour force participation rate. Some are returning, enticed by rising wages, and normalising immigration could eventually fill the gap. However, it is quite likely that unemployment will stay low for the foreseeable future. Meanwhile, rising stock prices have a positive wealth effect for the rich and savers, too, are benefiting from much higher interest income. All of the above is supportive of consumption across households of different income levels.
In fact, large consumer companies have demonstrated their growing pricing power against this resilient consumption backdrop, improving margins by adopting a price over volume strategy. As a result, both corporate margins and earnings are holding up well. There have not been any material downward revisions to earnings for 2023-24 over the last several months. Plus, there remains substantial pandemic-era liquidity driving asset prices higher (see Chart 3). Where does all this leave us?
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Will there be a US recession?
That is the trillion-dollar question. We know interest rate hikes work with a lagged effect on economic activities — we just don’t know the timing and how much of an impact. There is no question US GDP growth has slowed in the last three consecutive quarters, but there is also little evidence that a recession is imminent. At least not a broad- based one, though parts of the economy are already in “recession”.
Case in point: US manufacturing PMI has been in contraction territory for the better part of the past one year, as consumer spending switched from goods to services and businesses cut inventory stockpiles. We see the same trend in global manufacturing, which is underscored by falling exports in export-oriented Asean countries, including Malaysia and Singapore. And this downturn is reflected in stock prices for retailers such as Nike and Target, which are down 6.8% and 9.5% respectively for the year to date (at the time of writing), in contrast to gains for the bellwether indices.
The US housing market, too, has been in decline, especially after the US Federal Reserve began its interest rate hike cycle in March 2022. The mortgage rate (30-year fixed rate) more than doubled from 3.1% at end-December 2021 to over 7% in less than one year. Home sales (existing and new) as well as housing starts and building permits fell sharply in the immediate aftermath — but all are showing signs of stabilising and nascent recovery, as mortgage rates stabilised slightly below the November 2022 peak (see Chart 4).
Home prices have indeed turned higher in recent months, driven by renewed demand. Stocks for homebuilders such as D R Horton and Lennar are up 21.9% and 38.4% respectively, year to date, signalling optimism that the housing “recession” may be over. We think the US housing market recovery is sustainable, due to demographics and low inventory, and home prices should trend higher, albeit at a more normalised rate compared to the surge during the pandemic. We will write more on this topic in a future article.
Stock rally may have legs in short term
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With fears of an imminent US recession rapidly receding, there are indications that bearish professional money managers and individual investors are turning more optimistic and have started chasing the stock rally. Indeed, gains are broadening out beyond the mega caps in recent weeks (see Chart 2). As we have mentioned before, there is substantial cash on the sidelines — liquidity is ample — and fear of missing out (FOMO) may well spur the market higher in the short term. It is especially painful for active fund managers to continue being underinvested and hence, underperform in a rising market.
That said, we still believe that stock valuations are too high. And caution is warranted, perhaps even more so than at the start of the year. While the feared major downward revision in earnings has not materialised — as many had expected (in the event of a recession and weaker consumption) at the start of the year — the rally in 1H2023 means that valuations are now even higher. And, therefore, more vulnerable to any negative development and turn in sentiment.
For instance, Apple’s 47% year-to-date gains are driven primarily by valuation expansion rather than earnings growth. The stock is currently trading at 33 times trailing earnings, double its median price-earnings (PE) of less than 17 times over the past decade and well above its expected five-year growth rates. Apple became the first company to hit the US$3 trillion (RM14 trillion) market cap and now has the single largest weighting (7.6%) in the S&P 500 index in history — thus giving it an outsized impact on the market. Its rising valuations can be partly attributed to the growth in passive index-tracking funds — and, to a certain extent, investor flight to quality. That is, a defensive positioning amid heightened uncertainties, given the stock’s high liquidity, steady cash flow generation and strong balance sheet. It is, we believe, a major beneficiary of the “there is no alternative” (TINA) theme — where investors flock to stocks en masse, in search of returns.
Cash is no longer trash
Certainly, during the first two years of the pandemic, when short-term interest rates were cut to near zero, stocks were the TINA trade. Real yields (after adjusting for inflation) on cash deposits and other fixed-income investments, including the 10-year US Treasury, fell steeply into negative territory. In fact, savings in cash and investing in bonds for fixed income have been losing propositions for the better part of more than a decade since the global financial crisis (GFC). Real yields for the 10-year Treasury averaged well below 1% (prior to the pandemic) while real interest rates on cash were largely negative during this period — all far below historical rates of return (see Chart 5).
As a result, investors, including retirees, have been forced to take on more risks in the desperate search for yields (returns). According to a recent Wall Street Journal article, nearly half of Vanguard 401(k) investors aged 55 years and above and actively managing their money have more than 70% of their portfolios in stocks, up from 38% in 2011. At Fidelity Investments, nearly four in 10 investors aged 65 to 69 hold about two-thirds or more of their portfolios in stocks. A similar growing bias towards stocks is seen for investors aged 75 years and older — at a time when many should be lowering their investment risk profiles. As we have said before, low interest rate is a tax on savers.
The secular decline in interest rates drove the longest bull market in US history, which lasted from the post-GFC lows in March 2009 up until the Covid-19 pandemic. During this period, stock market returns far exceeded that from bonds, from a longer- term historical perspective (see Chart 6). This was also a period of sustained negative real interest rates. In contrast, when real interest rates are positive, stock prices do go up — but gradually so (see Chart 5).
Notably, though, this yield gap between stocks and bonds — that had widened post-GFC — has narrowed rapidly since the Fed started raising interest rates aggressively from March 2022. And, for the first time since the pandemic, cash (money market funds) now has positive real returns (see Chart 7). In other words, cash is no longer trash.
Nominal yields on the two-year Treasury note are now hovering around 5% while the 10-year Treasury yield has risen above 4%, the highest levels since well before the GFC. Will rising positive real returns on cash-bonds and narrowing yield gap for stocks over bonds lure investors back to lower-risk cash savings-deposits and fixed-income bonds? We do not know for sure, but there are good reasons that they might.
The economic resilience will give the Fed more leeway to raise interest rates further, to decisively stamp out inflation as quickly as possible. The Fed dot plot predicts a peak interest rate of 5.6%, about 50 basis points (bps) higher from current levels. Its primary objective is to keep inflation expectations anchored — by demonstrating the willingness to accept a weaker economy, even recession — and they are, so far. We believe the Fed will keep interest rates higher for longer, especially if inflation proves to be much stickier (and we think it is) than expected from current levels.
By all indications, the labour market is likely to stay tight for the foreseeable future. And there is less concern over the immediate impact of higher borrowing costs for households. Household debt as a percentage of GDP and personal disposable income is low from a long-term historical perspective. Mortgages in the US, often the biggest component in household debt, are mostly fixed-rate 15 to 30-year loans. In fact, some 60% of outstanding mortgages have been refinanced within the last four years, at very low rates.
Another 25bps to 50bps interest rate hike — assuming inflation expectations do not change — will mean higher real yields for cash (money market funds and deposits) and bonds. That will make them attractive alternative investments again for institutional investors such as endowments and pension funds, as well as more risk-averse individual investors.
This is especially so as the US economy slows further over the coming quarters, under the weight from the cumulative impact of interest rate hikes over the past year, even if recession is not imminent. And that raises the risks that current expectations for earnings growth, particularly for 2024, are too optimistic — and valuations too high.
Certainly, the long-term decline in interest rates — on the back of falling inflation — of the past few decades that had fuelled stock market gains is not likely to be repeated. Not with the reversal in globalisation and optimisation of the global supply chain — in favour of national security, resilience and protectionism — rising geopolitical tension and fragmentation of the tech ecosystem between the US-led West and China as well as, we believe, the underestimated costs from clean energy transition. Although we believe the generative artificial intelligence-driven productivity gains are real, the impact on companies may not be as immediate or as significant as Wall Street hype currently predicts. All these likely mean higher costs and inflation. Coupled with prevailing high valuations, the risk-reward proposition for stocks may not be as attractive as it was in the past. There will be, increasingly, competition for investor funds from rising real returns for cash and bonds. In short, stocks are no longer the only game in town.
The Malaysian Portfolio gained 1.2% last week, boosting total portfolio returns to 159% since inception. This portfolio is outperforming the benchmark FBM KLCI, which is down 23.6%, by a long, long way. The gainers for the week were Star Media Group (+3.6%), Insas (+0.6%) and ABF SG Bond Index Fund ETF (+0.4%) while Hartalega Holdings (-2.0%) was the sole losing stock.
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.
