Economic Insights for October 2022

The following are some economic insights for October 2022.  The global economic outlook continues to deteriorate.  The rebuilding of inventories continues to lose momentum while end demand is dampened by high inflation, tight fiscal policies and deteriorating financial conditions.  This is exacerbated by the shift in consumer demand from goods to services.  The peak in the technology cycle is expected to impact Asian excluding Japanese exporters in the second half of 2022, and most of 2023. 

Risk-off sentiment of investors resumed because of the higher than-expected CPI report.  This was magnified by the Federal Reserve’s latest hike by 75bps to reach 3%.  There is also an apparent commitment to raise the rate to about 4.25%-4.50% by year-end.  In this case, the inflation hawks are right, and they are making up ground on their initial reluctance to raise rates, which negatively affected the market.  The prolonged hawkish stance of central banks have triggered an increasing fear of recession.  This has caused the US dollar to rose against most major currencies because it is viewed as a safe haven asset. 

However, there are a few central banks still maintaining an easing bias. For example, the People’s Bank of China continues to pause monetary easing and has kept rate unchanged, in a context of mild inflation and uncertain economic outlook.  China cannot afford to risk an economic slowdown since this will loosen the Communist Party’s grip on power.  This is the obvious cause for the diverging US-China monetary policy trajectories.  This has fed much of the uncertainty of its domestic property market outlook.  Consequently, economists have been downgrading their growth forecasts to levels below the government’s target.  Furthermore, China’s zero-covid policy has an unclear direction, which further risk crippled the country’s outlook. 

Asset allocation decisions remain one of the largest drivers when determining the range of portfolio outcomes amid these volatile markets.  In the current environment of accelerated central bank rate hikes, the rising risk of recession, and potential rising unemployment across large developed markets, most funds have remained underweight for equities, and cautious on bonds with preference for lower durations.  The feeling is that growth is unlikely to bounce back quickly in the absence of central bank easing.  This has compelled many fund managers to set aside an increasing allocation to cash for liquidity.  Cash as an asset has begun to generate meaningful risk-adjusted return relatively. 

I would recommend remaining underweight for equities because of the risk of a hard-landing recession is increasing.  With weaker macro conditions, many feel that earnings expectations remain too optimistic, and negative revisions by in-house economists have begun. At the moment, valuation derating has been the driver lowering equity markets.  It is recommended to maintain neutral towards Asia excluding Japan equities for those already invested.  Whilst economic activity is increasing, the outlook still remains murky because local central banks have turned hawkish on inflation. 

Regarding investment grade credit, credit spreads look increasingly unattractive after the recent rally.  There is a potential hard landing, where default rates are expected push higher.  There is also a potential cascading default of sovereign bonds.  It is recommended to underweight US credits as its spreads widen further because of the economic slowdown.  Short-maturity credit are the closest proxy to cash-like investments. 

The aggressive Federal Reserve policy tightening because of the stubborn high inflation has caused bond yields to increase sharply.  This rapid bond yield increases have exacerbated liquidity constraints for some highly levered.  Short rates have been moving upward quicker than the long end.  This has caused the yield curve to flatten materially.  It is expected that higher rate volatility and weaker price performance will continue over the medium horizon.