• The STI was up a modest 0.9% in 3Q22. Only a third of the component stocks managed to eke out gains.
• We are bearish this quarter. We believe the US economy faces a high probability of a recession next year. Rising interest rates globally will further deflate both valuations and earnings.
• Singapore’s corporates are in much better shape, backstopped by a resilient domestic economy and rising interest rates bolstering bank margins.
Review: The STI was up a modest 0.9% in 3Q22. Only a third of the component stocks managed to eke out gains. Banks were the outperformers (Figure 1), and so were selected cyclicals (Figure 2). REITs bore the brunt of the sell-down (Figure 3). They face multiple challenges. Higher interest rates and flat property cap rates translate to negative carry from acquisitions, stifling inorganic growth. We also expect refinancing costs to spike not just from higher rates but costlier hedging to keep interest rates fixed. The ability to maintain DPUs will be a challenge
Outlook: Global growth continues to ease. Most macro indicators are at their lowest point since the pandemic began. There are no growth drivers on the horizon. Europe is facing a recession under the weight of skyrocketing energy prices. Energy rationing during winter could further depress the region. The Fed is intent on slowing the US economy with higher interest rates, while China remains gripped in a lockdown. Rising interest rates globally will deflate both valuations and earnings. We believe the US economy faces a high probability of a recession next year. Most leading indicators are flashing red, indicative of a coming recession (Figures 6 and 7). US corporates face the trifecta of an appreciating dollar, higher interest rates and rising material costs. And made worse by “just too much” inventory. In the past three recessions, earnings declined by around 20%. The forecast for 2022 is still mid-teens growth. Singapore’s corporates are in much better shape, backstopped by a resilient domestic economy and rising interest rates bolstering bank margins.
After major fiscal spending on the pandemic, governments have smaller balance sheets to reinvigorate their economies (Figure 8). The UK is trying to spend its way out of recession and energy inflation. But the cost is a 20% collapse in its currency (Figure 9) and surging government bond yields (Figure 10). China appears to be the only government with a balance sheet to support its economy and indicators point to an economy bottoming out (Figure 11). Another promising sign is the peaking of inflation. Headline inflation in the US is highly correlated to commodity prices (Figure 12), which have crested. However, it is not time to rejoice. Firstly, the critical core inflation is stubbornly high from rising rents (Figure 13) as the housing supply is still constrained. Secondly, oil prices are weak following massive selling of US strategic petroleum reserves (Figure 14). But that will end in November. Thirdly, for the Fed to pause its hiking cycle, core inflation needs to decline meaningfully and sustainably. A condition several months away (Figure 15). To address both the global plight of weak economic growth and stubborn inflation, capital expenditure needs to be revived. Investments will come from more onshoring of manufacturing capacity to buttress supply chains. They will also stem from a restoration of energy independence for security and climate agendas. Notable sectors that benefit from this in Singapore are semiconductor equipment makers and oil and gas vessel yards or owners.
Recommendation: We are bearish this quarter. We are stepping out of the casino for a coffee break. The typical equity hedge during a bearish phase is bond-like stocks such as REITs. But REITs are no longer a shelter with the steep ascent in interest rates. In general, a 2% point rise in interest rate requires mid-teens growth in property income just to maintain dividends. It is an insurmountable hurdle with accretive acquisitions using debt no longer available. To hedge out downside risk, we have added Singapore Exchange (SGX) to our model portfolio. We are buying volatility for the coming quarter. SGX benefits from rising rates due to its collateral float from member balances. On top of that, volatility in the market will drive up trading volumes. Banks are still Overweight for us. Variable-rate loans and the low-cost float of CASA deposits (current accounts and savings accounts) are rare beneficiaries of steepening interest rates. On REITs, we believe a more opportune time to Overweight the sector is early next year. Fed hikes at the current pace are not sustainable as we see a recession on the horizon. The FOMC’s December meeting could be a pivotal moment for that notorious Fed pivot to lowering rates or at least wait and watch.