SCB CIO unveils Q3 strategy
SCB CIO unveils Q3 strategy: Gradual transition to defensive US stocks and government bonds amid growth stocks’ stretching valuations and rising chances of US recession
The SCB CIO observes major central bank interest rates nearing a halt while remaining high, while US and European economies are expected to enter moderate recession. Asian emerging markets’ economies have recovered less than expected but are still progressing. To mitigate the risk of recession, investors should consider government bonds of developed countries and reduce the allocation of growth stocks in the US as their value have become pricey and be cautious with European stocks that may be impacted by prolonged high inflation. Instead, a gradual shift toward defensive US stocks as well as Chinese A-Shares and Thai stocks is suggested as their valuations remain relatively attractive.
Dr. Kampon Adireksombat, First Senior Vice President and Team Head of the SCB Chief Investment Office at Siam Commercial Bank, has stated that major central banks are signaling the end of the interest rate hike cycle likely to take place in the third quarter this year, meanwhile the rate cuts decisions should take place in 2024 rather than in the second half of this year. With higher for longer interest rates, the US economy is displaying signs of deceleration, yet persistent inflation exceeding the target level has led the Fed to maintain a high policy rate of 5.5% throughout 2023. Meanwhile, the European Central Bank (ECB) is compelled to continue raising interest rates. In response to rising inflation, the Bank of Japan (BOJ) has started indicating an adjustment in its yield curve control policy. Additionally, the People’s Bank of China (PBOC) and the State Bank of Vietnam (SBV) have initiated monetary and fiscal policy easing measures as their economic recovery were slower-than-expected.
The SCB CIO holds the view that the United States and European economies are experiencing a slowdown and might enter a recession, albeit not a severe one. The US economy is clearly exhibiting a declining trend, with the labor market being a key factor that could potentially trigger an economic recession, but not to an extreme degree. Notably, the Fed has recently revised its 2023 unemployment rate forecast downward from 4.5% to 4.1%. The European economy is also demonstrating signs of deceleration, prompted by Germany’s technical recession in 1Q23 due to persistent high inflation and interest rates.
Although the recovery of the emerging market economy in Asia (EM Asia) has been slower than anticipated in the first half of the year, there is a persistent inclination toward recovery. The Chinese economy, while not fully restored, has experienced a slower-than-expected recovery. The government has recently begun signaling a relaxation of monetary policy by reducing interest rates, and there is a tendency for further fiscal measures to be relaxed. The Thai economy has continued its recovery primarily due to consumption and the service sectors, although political uncertainty continues to exert pressure on investments. Meanwhile, the Vietnamese economy is expected to be sluggish, hindered by contractions in the export sector and a slow rebound in the real estate sector.
When considering the risk factors that require attention, particularly in a worst-case scenario, we believe that prolonged inflation is the key risk factor that could exacerbate a more severe recession in the US economy. This would lead to continuous interest rate hikes by the Fed in 2H23 and potentially impact the global economy, especially EM Asia, which heavily relies on exports. In such a case, the SCB CIO anticipates that most central banks, which have already established policy space, will be able to implement interest rate cuts in 1H24 to support the economy, counteracting the previous interest rate increases.
Dr. Kampon says that in 3Q23, the SCB CIO advises taking steps to mitigate the risk of a recession. This includes investing in government bonds while reducing exposure to growth stocks in the US and European markets as their value tightens. It is recommended to shift investments toward defensive stocks in the US, with a particular focus on attractive opportunities in EM Asia, such as Chinese A-shares and Thai stocks.
To counteract the economic slowdown, the strategy involves gradually increasing holdings of government bonds. This is based on the anticipation of a decline in US government bond yields over the next 6-12 months due to slowing US inflation and the expected trend of halting Fed’s interest rates in 2H23, with a potential interest rate cut in 1H24. However, the view on investment-grade corporate bonds (IG) is downgraded to neutral due to the risk associated with medium-grade (A+ to BBB-) bond spreads that may be impacted by the risk of a recession.
We recommend reducing exposure to US growth and European stocks as their value tightens, despite the high interest rates and the slowdown in the economy. Particularly, growth stocks in the US technology sector have experienced a significant rally recently, with the S&P500 (forward P/E 19.1x; +0.1 standard deviation) showing strong gains and the Nasdaq100 (forward P/E 26.5x; +1.0 standard deviation) starting to tighten. In Europe, where economic recovery and earnings are likely to be affected by prolonged inflation and high interest rates despite its valuation remains inexpensive (forward P/E 12.5x; -1 standard deviation). Instead, we recommend shifting investments to defensive stocks in the US that exhibit strong profitability even during a recession. Opportunities in utilities (forward P/E 17x; -1.1 standard deviation) and consumer staples (forward P/E 19.7x; 5-year average) offer interesting valuations.
Additionally, adding EM Asia stocks, particularly focusing on China A-shares (positive outlook) and Thai stocks (slightly positive outlook), is recommended. Chinese A-shares not only demonstrate performance recovery but also benefit from supportive factors like eased monetary policies. They are relatively inexpensive compared to historical levels (forward P/E 11.3x; -0.5 standard deviation) and in comparison to MSCI world (forward P/E discount of Chinese stocks; -1 standard deviation). Despite political uncertainty, Thai stocks present opportunities driven by economic trends, company performance, and the ongoing recovery of tourism, service sector, and employment (forward P/E 15.3x; -0.5 standard deviation), making them relatively cheaper than other ASEAN stocks.
Furthermore, diversifying investments in commodities can serve as another option to hedge against prolonged inflation and geopolitical risks. Our analysis suggests that including commodities in the investment portfolio enhances overall efficiency. Allocating between 5% to 10% of the portfolio to commodities is appropriate based on the desired level of risk. While stocks and bonds tend to fluctuate in a positively correlated manner, commodities exhibit a negative correlation, making them effective diversifiers.
