Review: The STI was down 6% in 3Q19. Trade war fears threw global equity markets into a risk-off mode and triggered a scramble for bonds and bond proxies, namely REITs. The S-REIT index was up 8% this quarter. Of the STI’s 30 STI stocks, only four yielded positive returns. Although our model portfolio outperformed the STI, the macro backdrop we envisaged did not materialise. We had expected the trade war to wind down and interest rates to claw modestly up. But two tariff tweets later squashed these prospects. I guess predicting Trump is futile. As trade tensions ratcheted up between the U.S. and China, fears of a recession spiked. An inversion of the yield curve placed everyone on recession watch. The 10 year-3 month US Treasury yield inversion has predicted the past seven recessions. A better track record than the several hundred PhD economists at the Fed.
Outlook: We are anticipating low (interest rates) and slow (economic growth) 4Q19. But no recession. There are several reasons a recession is unlikely: (i) only the 10 year-3 month Treasury curve is inverted. Not the 10year-2year curve is not inverted; (ii) US corporate yield spreads should be widening rather than narrowing, as they currently do if the market is truly spooked by credit quality and an economic slowdown; (iii) recession come typically with a surge in credit, runaway inflation or excess corporate investments. None of these conditions is present; (iv) central banks around the world are inflating their economies via lower interest rate and fiscal stimulus, mostly in the emerging markets such as Thailand, S Korea, China and India; (v) finally, we think yields will come closer to zero if bond markets are indeed pricing in a recession. On the US-China trade talks, we do not see any push factors for a meaningful truce anytime soon.
STI Target: We lower our STI target to 3400 (3600 previously). This will peg STI at 13x PE, below its historical 14x PE. A 4Q19 rally is possible as the global manufacturing downturn looks extended after falling almost 2-years.
Recommendation: Our model portfolio – Phillip Absolute 10 – was down 2.4% in 3Q19. As a consolation, we did outperform the STI. Our sector bet on banking stocks did not pan out. Public protest has become a drag on the Hong Kong economy and the tapering of SIBOR interest rates will cap future upside in interest margins. Both DBS and OCBC have around 20% of their earnings exposed to Hong Kong. Nevertheless, on balance, we still favour banks. They offer value, reasonable earnings growth of 9% this year and an attractive dividend yield of 5%. We are adding some cyclicality to our model portfolio by including Venture Corp. Its share price is 20% off its peak and valuations are turning more attractive. In our initiation report, the company is capturing a larger share of contract manufacturing industry profits as it piles on higher value-added services. Disruption in China’s supply chain has diverted more order flows into South East Asia, including Malaysia where Venture has a large presence. Venture Corp has replaced ComfortDelGro in our model. Another change we made was to switch APAC Realty with PropNex. The latter has been capturing more market share, especially in new launches.
3Q19 Performance Review – Phillip Absolute 10
The Phillip Absolute 10 model portfolio was down 2.4% in 3Q19 (YTD19: +11.6%). As a consolation, our outperformance over STI widened to 9.9% points. Yield and selected stocks such as SGX and Sheng Siong were resilient. We missed the rally in REITs. Our expectations that REIT dividend yield spread over sovereigns was turning too compressed (i.e. expensive), faltered. After trade talks between the U.S. and China worsened, there was a rush to safety and yield or more defensive stocks, namely REITs.
Our bet on financials did not materialise. The lingering protest in Hong Kong negatively impacted the banking stocks, in particular, stocks with significant Hong Kong operations, namely DBS and OCBC. Another dampener was the tapering of SIBOR which will fell 13bps as of September 2019 from the peak of 2.007% in May 2019. We still favour the banks for their valuations, reasonable earnings growth of 9% this year and attractive dividend yield of 5%.
We will be replacing ComfortDelGro and APAC Realty with Venture Corp and PropNex.
1. We removed ComfortDelgro and replaced it with Venture Corp. The pressure on the taxi business remains intense. The taxi fleet industry in Singapore is contracting 9% this year. In contrast, car rentals are up 3%. Taxis are losing market share to private hire vehicles. The re-rating of Comfort from the exit of Uber, stricter regulatory rules on private vehicles and a more profitable bus contracting system have largely been priced in.
2. We added Venture Corp into the portfolio for several reasons: (i) Venture has been capturing an increasing share of contract manufacturing industry profits as they step up their value-added services; (ii) the weakness in electronics demand looks extended compared to previous cycles; (iii) due to the trade war, the electronics supply chain is shifting out of China and outsourcing more from SE Asia, where Venture has a large presence in Malaysia; (iv) we think Venture can sustain their dividend yield of 5% from operating cash-flows and their S$760mn net cash on the balance sheet.
3. Another change was the switch from APAC Realty to PropNex. Whilst we like both stocks for the oligopolistic nature of the industry and favourable return dynamics, PropNex has executed well in extending their market share and growing the pool of agents.