Investors should remain positioned for upside in H2

Below is a commentary I wrote that was published?by The Straits Times here.

Fuelled by the strong global economic recovery, stocks have continued to rally this year. Benchmark indices in the United States and Europe have gained close to 15 per cent, with energy (30 per cent) and financial (20 per cent) equities surging worldwide. Commodities, too, have jumped, led by oil (45 per cent). Asia has been more of a mixed bag, with the MSCI Asia ex-Japan Index up just 5.5 per cent. China has been hit by regulatory uncertainty and the growth-to-value rotation amid rising US rate expectations. More broadly, Asia's slow vaccination pace has weighed on prospects for reopening.

Heading into the second half of the year, the outlook is marked by risks and opportunities alike. On one hand, the risks are more pronounced, with central banks on the move and inflation on the rise. But on the other hand, good news on the vaccination front and global economic strength are reasons to stay upbeat.

Overall, we see more upside to stock markets in view of robust earnings growth, attractive valuations and policy accommodation. But equally, we expect nerves to be tested in the second half by an array of risks relating to the Federal Reserve, inflation and China.

Risks on the horizon

The foremost risk is a hawkish turn, real or perceived, by the Fed. Acknowledging the stronger than expected recovery in the US, the Fed may now be more open to hiking interest rates earlier and reducing asset purchases sooner than previously thought.

Fed commentary is always a source of volatility, but we think tapering is only likely to begin early next year and rate hikes in 2023. Inflation is another factor. Surprise leaps in consumer prices led to fears of runaway inflation, and this debate is likely to continue in the second half.

But investors should not panic.

Much of the price surge since April is due to temporary supply-demand dislocations as economies suddenly restart at a time when businesses are hardly holding any inventories.

Sustained inflation above 3 per cent is unlikely in the midst of technological shifts, ageing populations and wealth inequality. The recent spike in consumer prices should fade as the year progresses.

Still, fiscal activism combined with a new "average inflation targeting" framework means US inflation could eventually settle at a higher 2-2.5 per cent range compared with the pre-Covid-19 average of 1.5-2 per cent. Asia should also see contained inflation rates, and central banks are likely to look past any surprise jumps.

China's recovery, meanwhile, is losing some steam. After a blistering first half, the economy is getting pressured by subsiding pent-up demand, property policy tightening and squeezed margins from surging raw material prices.

Beijing will likely look to support the real economy through liquidity injections, small business loans, and local government bond issuance, meaning a slower but still decent growth rate of around 5-6 per cent year on year in the second half of this year.

Near-term opportunities in Asia

Notwithstanding these worries, we think Asia will catch up in the months ahead. Vaccination rates are quickly ramping up, thanks to improved supply and a renewed urgency after the Delta variant swept across societies that previously had the virus under control. China, for one, is now vaccinating over 1.2 per cent of its population daily.

By 2022, we believe Asian earnings are set to be around 50 per cent higher than the pre-pandemic level, yet the region is trading at a 35 per cent discount to global markets.

We are optimistic and find two markets particularly appealing: China and Japan. The MSCI China index is trading around 17 per cent below its February peak. This presents a good opportunity for investors to buy the dip.

China's energy, materials and financial sectors have lagged behind their global peers and will likely benefit from the country's reopening. The leading Internet platforms, which have strong balance sheets and cash flows, now trade at huge discounts to their US peers.

Japan has also underperformed, with the MSCI Japan Index down two percentage points versus the MSCI World Index this year. But the market looks set to rebound as Japan reopens more sustainably with the vaccination roll-out accelerating.

Secular trends to pursue

The IMF expects Asia's gross domestic product to grow by around 6 per cent per year over the next six years and that by 2025, China will be larger than the rest of the G-7 (excluding the United States) combined. But what is most exciting is not just the pace of growth, but that China and the rest of Asia are sitting at the intersection of major secular trends - including digitisation, the bifurcation of supply chains and the green revolution - that have been accelerated by the pandemic.

Consider the green boom. Asian governments are actively reshaping their economies for a greener future. China's decarbonisation targets, for example, will likely drive a two-fold rise in solar instalments, 40 per cent growth in wind instalments and a five-fold increase in electric vehicle production by 2025, according to our estimates.

Meanwhile, the global energy transition is only about 10 per cent completed today. For developed economies to achieve their net-zero targets, the key supply chains - from critical minerals to solar glass to batteries - will have to run through Asia and China.

Other areas like South-east Asia's new economy, China's digital economy, the global 5G roll-out and digital subscriptions are also promising themes to consider for long-term exposure.

How to prepare for the volatility

Waiting for risks to subside and markets to bounce can be an indefinite and costly endeavour. Instead, investors should actively seek to manage their risks and to prepare for the volatility ahead.

To hedge against inflation, investors can incorporate stocks with pricing power - or the ability to pass on higher costs - which can be found among dominant players in the communication services and consumer discretionary sectors.

Other options include short-duration bonds, which are less sensitive to rising long-term yields, private market infrastructure assets and commodities via broad indices

To protect against market risks, investors can diversify their exposure into more defensive stocks in the financial and healthcare sectors. As the correlation between bonds and equities turns increasingly positive, investing via hedge funds is another defensive way to build market exposure. They typically exhibit a lower beta to global markets and benefit from a strong?focus on risk management and downside mitigation. Investors can also reduce downside exposure through options and structured investments.

The investment climate may become more challenging but opportunities are aplenty. Investors should remain invested, diversified and positioned for upside.

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