Have financial markets turned the corner?

Below is a commentary I wrote that was published?by The Straits Times on 6 February.

It’s been an auspicious start to the year for financial markets.

Global equities are up more than 7 per cent year to date, with Asian stocks rallying into a bull market. Fixed income markets have seen healthy inflows, commodities are picking up steam, and the regional currency outlook has turned more constructive as?US dollar strength fades.

The upbeat mood has all the makings of a clear inflection point. After all, recent developments offer reasons to be optimistic. China’s big reopening has gone off without a hitch, inflation appears to be past the peak, the US Federal Reserve is slowing its pace of rate hikes, and an energy crisis in Europe has been largely averted by warm weather.

But markets have a habit of front-running actual turning points in the economy, making them tricky to spot and even trickier to time. Indeed, the backdrop still remains one of high inflation, rising rates and slowing economic growth.

So, will the current rally in risk assets prove durable, or have investors sprinted too far ahead? In our view, turning points are approaching, but at different speeds for different markets. That means selectivity will be rewarded, and investors ought to reflect that accordingly when positioning.

The state of play

Several narratives are playing out on the growth front. China’s?grand reopening has been a success story so far,?with mobility and tourism staging a strong rebound during the Chinese New Year holidays.

Official data also shows the peak in Covid-19 cases is behind us, kickstarting a recovery in consumption that we think will reach around 7 per cent in 2023 from near zero in 2022. That should put China’s gross domestic product growth above 5 per cent in 2023 and drive a 4.5 per cent expansion in Asia – a pace that could be exceeded if the better-than-expected momentum continues.

By contrast, growth elsewhere will likely remain tepid. A mild winter and lower gas prices have reduced the risks of a recession in Europe, but we still see only flat or slightly positive economic growth. Meanwhile, recent data points to a US economy that is likely to enter a mild recession in the second half.

More encouragingly, inflation is?evidently falling from the peaks seen in late 2022.?The US consumer price index came in at 6.5 per cent year over year in December, down from the peak of 9.1 per cent in June, while the Fed’s preferred core personal consumption expenditure gauge eased to the slowest annual pace in over a year at 4.4 per cent year over year. In Europe, December inflation decelerated to 9.2 per cent year over year from 10.1 per cent year over year in November.

Uncertainty does remain over how smoothly inflation can fall back to target as labour markets remain tight. But the decline is already allowing central banks to slow the pace of their tightening, underscored by the Fed’s recent 25-basis-point (bps) hike after a 50bps move in December and four consecutive 75bps hikes in 2022.

Federal funds futures are now calling for a peak in rates around 4.9 per cent in June, while most Fed officials expect a peak between 5 per cent and 5.25 per cent. The timing of future rate cuts, however, is more contentious, but we are optimistic the Fed will consider easing towards the end of 2023 to soften the US economy’s landing.

How to position

Market rallies are often swift at key turning points.

With the Fed now closer to the finish line than other major central banks, downward pressure on the US dollar could continue to mount and long greenback positions should be avoided. In the meantime, falling interest rate volatility should provide a constructive backdrop for quality income and yield pick-up strategies.

Importantly, China’s reopening and coming recovery present some of the most compelling global opportunities available right now. In particular, emerging market equities should continue to outperform, with price-to-book valuations at a 40 per cent discount to developed countries and earnings momentum nearing a bottom – all as waning dollar strength eases financial conditions.

Chinese equity valuations are still attractive as well, and offer an expected earnings per share growth of 14 per cent that should outpace Asia ex-Japan (6 per cent) this year.

Here, domestic consumer, Internet, medical equipment and transportation stocks are set to enjoy more front-loaded returns as China’s consumption recovery picks up.

Elsewhere, European stock markets have the second-highest exposure to China among any region (8 per cent of sales) while the US hosts several gaming and consumer brand companies that are highly leveraged to Chinese spending. In Asia, tourism-related assets and commodity companies are likely to see a significant boost.

Energy and base metals should also benefit from the upswing in Chinese demand and construction activity. We are bullish on commodities overall and forecast total returns in the high teens this year. Meanwhile, the Australian dollar is a China proxy that should also benefit from Australia’s relatively stronger economic growth and more hawkish central bank.

By contrast, US stock valuations do not yet fully reflect the earnings contraction we expect in 2023. The risk-reward remains unfavourable for broad US indexes and we recommend fading the rally in US growth and technology stocks.

The positive start to 2023 is a welcome respite from years past. But not all markets are fully out of the woods just yet, and investors should remain selective in the months ahead.

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