The world is never short of surprises. Not too long ago, money markets were more aggressive than the Fed‘s projections for rate cuts, the so-called ‘Dot Plot’, having priced 150 basis points of cuts this year. The strong March US payroll employment report and inflation prints have upended such optimism and thrown the much-anticipated Fed pivot on rates into a tailspin. If you don‘t find it challenging enough, Iran-Israel tensions are adding fuel to the fire. To navigate this environment, as investors, we should play both defence and offence. We play defence by maintaining an all-weather foundation portfolio, diversified across asset classes and geographies, as an anchor. Meanwhile, we can take an offensive approach by adding targeted, opportunistic ideas around the core portfolio to exploit market dislocations.
Opportunity 1: Divergence in the timing of rate cuts
The US has experienced a more resilient job market and stickier inflation than Europe, due to unique factors such as a surge of immigrants. As opposed to the prior belief of a concurrent rate pivot mid-year, the ECB looks increasingly likely to kick off the next rate cutting cycle sooner than the Fed. Therefore, we recommend using the recent spike in bond yields to buy EUR-denominated investment grade bonds, from which we expect greater price gain potential than the USD-denominated bonds.
Opportunity 2: Add hedges against inflation and geopolitical tensions
While it remains to be seen if the recent upswing in US inflation was just a “bump in the road”, we cannot underestimate the upside risk, particularly considering higher oil prices led by another flare-up in Middle East tensions and drone attacks on Russian refineries by Ukraine. Increased geopolitical uncertainty in the next couple of months adds tailwinds to inflation hedges. We believe US Treasury inflation protected bonds (TIPS) and the US energy sector can likely act as good inflation hedges. TIPS can outperform government bonds when inflation comes in above expectation. Meanwhile, consensus expectation of a 5% year-on-year earnings decline for the US energy sector has yet to price in the 10% rally in oil prices from the average level a year ago. US energy stocks are also likely to act as a hedge against any intensification of Middle East tensions and a Trump victory in the upcoming US presidential election, given his supportive stance towards the conventional hydrocarbon industry.
Opportunity 3: Earnings growth to diverge in the US
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While on US equities, we anticipate investors to become more discriminating heading into the Q1 earnings season, in light of the current equity valuation and positioning levels. The good news is that market expectation is subdued, assuming only 5% Q1 earnings growth for the S&P500 index. As opposed to a broad base of positive surprises, we expect upside to come mainly from a narrow scope of industries, including communication services and technology. The key social media platforms have benefitted from an incrementally favourable advertising outlook, while technology strength extends from high-end AI chips to memory chips, evidenced by a leading US chipmaker‘s recent price hikes. The recent pullback in US equities provides an opportunity to rebalance and broaden our exposures into these areas with potential upside to earnings outlook.
Opportunity 4: India large-cap equities and onshore government bonds
The consensus expects India large-cap equities to grow earnings in the mid-teens in the upcoming year. We see risk to the upside, led by resilient credit growth, benign inflation, and strengthened manufacturing outlook (with PMI rising to 57.5 from an already strong level of 55.5 in the prior quarter). In that sense, India stands out from the mixed outlook facing major markets, justifying the equity market’s forward P/E valuation, which remains slightly above the historical average at around 21x. Hence, we remain bullish on India large cap equities at these levels.
Another hidden gem in India are the onshore local currency bonds, which currently yield in excess of 7%, superior to the emerging market peers’ average of 6.3%. The onshore bonds are slated to be included in a global bond index for the first time in history this quarter. Given our anticipation of a relatively resilient INR, bolstered by the strong fiscal position and foreign exchange (forex) reserves, we believe the upcoming election will likely result in policy continuity, spurring domestic and foreign fund inflow into India’s capital markets.
Opportunity 5: China non-financial high yield state-owned enterprises
China is going through a cyclical upturn, albeit a modest one given the disciplined policy approach. Mixed economic prints, including weaker March trade growth and new loan growth, suggest need for further monetary easing. This augurs well for equities of high-dividend non-financial state-owned enterprises (SOE), which are mandated by authorities to enhance market cap as one of their new key performance indicators. The combination of attractive dividend yield and good appreciation potential (at low valuations, given China is under-owned among international investors) makes this an interesting investment case.
In all, this analysis is meant to illustrate that, amidst all the uncertainties, we are not short of tactical investment opportunities. This does, however, require a higher degree of selectivity and due diligence than seeking broad market exposures. It reinforces the importance of international investing, which not only helps diversify our investment portfolio, but also allows us to participate in any particular market’s growth or macro outlook.
Raymond Cheng is the chief investment officer for North Asia at Standard Chartered Bank’s wealth management unit
