Too hot, too cold, or just right?

In the popular fairy tale, Goldilocks decides to try three different bowls of porridge in the empty home of three bears. She finds the first too hot, the second too cold, but the last one “just right.”

Investors too are hoping financial conditions turn “just right” for portfolios before the bears return to the table. After all, steady global growth, an encouraging earnings season, and rapid AI adoption are all reasons to be optimistic that an upside Goldilocks scenario can materialize. Such expectations have helped last year’s outperformers extend their gains into 2024 (TOPIX +12% YTD, Magnificent 7 +8.8%), with the S&P 500 already establishing 11 new all-time highs this year.

But recent data show the US economy still remains too hot for the Federal Reserve to begin cutting rates, while China’s economy remains too cold for investor comfort amid deflation and a struggling property sector. Until these complications are resolved, we see only modest additional upside for assets this year at the broad index level in key developed markets.

There are still, however, specific opportunities within these markets where the risk-reward already looks “just right.” In particular, we like US tech, US small caps, large-cap Japanese banks, and Europe’s own Magnificent 7, which includes innovative market leaders in European luxury, pharmaceuticals, and industrials. Globally we also have a most preferred stance on EM equities: India and Indonesia are solid structural growth stories, China’s defensive sectors offer high dividend yields and inexpensive policy upside, and Asian AI beneficiaries provide better value versus their global peers for investors looking to diversify their tech holdings.

A Fed affair

The timing and extent of Fed rate cuts are key to Asia’s prospects. Robust US growth data has reduced easing expectations, reset bond yields higher, and helped the dollar recoup its 2023 losses, but we still expect the Fed to cut rates by 75bps starting in June.

This would be a constructive outcome for the region: Not only can Asian central banks ease policy rates from mid-year onwards too, particularly as local inflation trends toward 2% (from 2.5% currently), solid US growth is also supporting a global tech and manufacturing recovery that should benefit cyclical exporters (North Asia), sectors (tech, consumption), and currencies (KRW, SGD).

Indeed, a look back at previous Fed easing cycles during periods of positive growth shows Asian ex-Japan equities delivered high-single digit median returns in the months after a first cut (versus near 0% at times when the Fed has cut during a US recession). The conclusion is intuitive enough: Risk assets tend to do well when economies are growing and rates are falling.

Policy heat needed in China

China begins the Year of the Dragon with a lack of fire in its economy. Though Lunar New Year travel and spending bounced past pre-COVID levels, consumer prices deflated at the fastest pace in 15 years (–0.8% y/y) in January, while sales at the country’s top 100 developers contracted another 35% y/y.

Market sentiment is gradually starting to stabilize thanks to a string of positive policy developments. After plunging 12% in the first 16 trading days of 2024, MSCI China has climbed around 10% from its YTD depths as policymakers stepped in with measures to support the market and the “National team” began buying.

We do think a more holistic approach is still needed to address China’s well-known trifecta of property, deflation, and debt challenges, making the upcoming Two Sessions a major policy test. But given the extent that these concerns are already in the price, we think the balance of risks for Chinese equities is skewed to the upside.

In particular, we like high-yielding names in the SOE-heavy financials, utilities, and telecommunications sectors. Select Hong Kong companies with strong balance sheets, resilient dividends, and sensitivity to falling US rates can be a lower risk proxy to Chinese upside.

Japanese equities reach a record high

For all the parallels drawn between Japan and China in recent years, few could have seen this coming: In 2023, Japan’s nominal growth rate (5.7%) overtook China’s (4.6%) for the first time in more than four decades.

We see more gains ahead for Japanese equities after the Nikkei 225 broke through a record high set in 1989. Corporate reforms are accelerating, with businesses giving in to shareholder pressure to unwind their cross shareholdings. The result is likely a broadening of share buybacks, representing an earnings per share growth driver for Japanese equities over the medium term.

On the macro front, we expect solid wage growth this year compared to last (3.6% y/y), meaning the BoJ is likely to end its negative interest rate policy in 2Q24. But a still-negative output gap means the central bank is unlikely to tighten much beyond that, creating just the right macroeconomic environment for risk assets.

Japanese banks outperformed the benchmark index in 2023, but the sector’s P/BV at 0.7x is still below pre-2016 levels when the BoJ first introduced negative interest rates. We expect a rerating higher as profitability improves, share buybacks are undertaken, and a dividend yield of 3.5–4% remains attractive.

We also expect the JPY to rebound once the Fed signals its readiness to cut rates toward mid-2024. We believe investors should go long the yen versus low-yielding currencies such as the TWD or CNY (instead of the high-yielding USD) to reduce the carry costs of the position.

Asia’s growth opportunities

India offers the best structural growth story in the region yet continues to be overlooked by some global investors. We expect real annual GDP growth in excess of 6% over the next five years, and corporate profit growth in the low-to-mid teens, likely supported by policy continuity after this year’s elections.

We are also upbeat on the post-election macro outlook for Indonesia. The new leadership inherits an economy in good shape, characterized by subdued inflation, solid FDI and infrastructure capex, and room to lower interest rates.

We stay most preferred on equities in both these markets, and also favor their high-yielding currencies against the low-yielding CNY and TWD. Strong sovereign fundamentals make Indonesia IG bonds attractive relative to their peers as well. Thematically, we like local consumer proxies offering resilient growth at compelling valuations, and banks.

For investors looking to optimize their tech exposure, Asia also offers a wealth of AI beneficiaries trading at reasonable valuations, including supply chain names exposed to AI edge computing. Those still underinvested in the sector should position in tech leaders with significant market share—we recently raised our global tech (IT and internet) 2024 EPS growth forecast to 18% y/y from 16%.

The three bears: Geopolitics, geopolitics, geopolitics

Geopolitics still represents the main market risk for Asia. This month, we identify three key areas to watch, related to the upcoming US elections:

1. The potential imposition of tariffs
2. The future of green and mobility incentives
3. Fiscal spending

While still early, potential winners and losers are emerging no matter who takes office. Further technology restrictions on mainland China could benefit Taiwanese foundries and Korean memory suppliers, and hurt most Chinese semi companies—though select mature node process companies may gain from domestic demand and policy support.

For those worried that the bears could return and ruin the fun for Goldilocks, now is also an opportune time to hedge market risks through defensive structured strategies, gold (also a beneficiary of lower rates), and alternatives like hedge funds.

Written with Mark Haefele , our Chief Investment Officer.

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