Indonesia, 06 Jul 2022 - Rising Above Inflation

Whilst the Russia-Ukraine crisis and Covid situation in China still have no clear end in sight, we believe they have been substantially priced in by markets. Heading into 3Q, the key challenges confronting markets are that of persistent inflation and a hawkish Fed, as well as rising risk of recession and earnings downgrades.

Against this inflationary and volatile backdrop, we reaffirm our preference for quality equities and price setters with strong market positioning, resilient profit margins, and ability to pass on increased costs to consumers, such as commodity-related sectors. On fixed income, short-dated, high quality credit stands out as an attractive alternative to holding cash. We continue to emphasise alternatives, including gold and private assets, as an important portfolio risk diversifier. Given the persistence of inflation driven by commodity shortages, we also highlight commodity investing as a satellite play. We believe these strategies will help portfolios to rise above inflation.

1.  Equities – Remain Bullish on China

China offers an attractive risk-reward – We turned bullish on China in 2Q22 as we believe Vice Premier Liu He drew a line in the sand by stating China’s commitment to support growth and business regulation. In validation of our call, China equities have indeed outperformed global equities by 14.9% since our call.

We believe that this outperformance of China Tech (and by extension the broader China market) will continue, buoyed by the three “C”s:

1. Cheap – Despite outperformance YTD, China equities continue to trade at a significant 37% discount to global equities on a forward P/E basis, which represents great value for investors. China is also massively under-owned as global equity funds have greatly underweighted China relative to benchmark weights for the past decade. This massive underweighting of China amongst institutional investors is expected to bottom out at current levels.
2. Clarity – We have observed signs of easing in China’s Tech crackdown, with China encouraging more homegrown Tech listings to reduce the over-concentration of power in China Big Tech.
3. Catalysts – Policy support is suggested by Chinese regulators’ allocation of USD2.4t to public expenditure in 2022 in their bid to revive the economy. Domestic corporate earnings growth is expected to rebound to mid-teens in 2023.

2.    Equities – Reaffirming our long-term constructive call on US Big Tech

We continue to advocate exposure to quality plays especially Big Tech in the S&P500, despite the acute sell-off in “long duration” Tech-related plays driven by rising bond yields.

• US Big Tech is backed by robust earnings, and rising bond yields have limited impact on the long-term fundamentals of this space. Economic moat characteristics (strong network effect, high switching costs, and rich Intangible assets) will continue to ensure resilient earnings.
• Historical data suggests that the recent correction was driven predominantly by the recalibration of investors’ expectations, and valuations are attractive after the recent sell-off.

Stay the course with these quality companies which have historically demonstrated the ability to outperform during periods of volatility.

 

3.    Equities – Upgrade Japan to Overweight

In line with our equity strategy to go for quality and price setters, we upgrade Japan to Overweight and look to gain exposure to Japan “Sumotoris”, or heavyweight companies with durable competitive advantages globally. We believe the following provide catalysts for Japan’s outperformance in 3Q22:

1. Higher fiscal headroom - Kishida’s government is expected to launch additional stimulus to strengthen domestic sentiment before the upper house elections, on top of a record annual budget passed in March and an additional stimulus package unveiled in April to cushion the impact of rising oil and food prices on the public.
2. Easier monetary conditions and a weakening Yen – In contrast to monetary tightening in most developed economies, the BOJ is expected to maintain existing Yield Curve Control Policy framework to keep the economy buoyant. The Yen’s resultant weakening provides further tailwinds for the earnings of Japanese exporters and greater value for foreign investors.
3. Attractive valuations of Japanese equities – Japan’s valuation trade stands at 13x P/E and is attractive compared to 16x for the World equities. Furthermore, the persistence of low bond yields in Japan translates to a larger yield gap for Japanese equities vis-à-vis world equities (the latter currently stands at 7.1% vs 3.0 for global equities).

4.  Fixed Income – Focus on quality

Amid the current environment of uncertainty, it is natural for risk-averse investors to seek the safety of cash. Yet investors banking on rate hikes to increase the returns of cash deposits may find themselves disappointed given a historically declining Fed Funds trajectory. As such, some element of risk-taking is still necessary for investors to beat inflation.

• Remain up in quality amid rising volatility – Given risks of a recession, investors seeking additional returns through credit risk should remain up in quality. Furthermore, good quality credit is now attractively priced, with global IG yields at c.4.4% – exceeding even the peak of the Covid crisis. These attractive yields are expected to beat cash returns even with rising rates.
• Within IG credit, the sweet spot lies in short-dated durations of 3 to 5 years – Based on cumulative returns since 2003, short-duration IG has displayed a stellar track record in rising above inflation.
• Asymmetry in outcomes benefitting investors – Should the Fed moderate rate hikes, short-dated, high quality credit will avail investors to potential capital gains.

We view this risk-reward as advantageous for investors to switch from cash to short-dated, high quality credit – capitalising on the certainty of income generation while most other risk assets grapple with volatility.

5.  Diversify with Alternatives, maintaining our Overweight call

We continue to be Overweight on Alternatives, comprising private equity, private debt, hedge funds and gold, for their diversification benefits.

• Gold as a stagflation hedge; gold target price at USD2,200 by year end
  Our outlook for gold is underpinned by the movements in the dollar and bond yields. Our target price is supported by our views that (i) The dollar has traded past its peak in 2Q22; and (ii) The Russia-Ukraine conflict could drag, driving demand for gold as a portfolio hedge.
• Private debt – Direct lending strategies
  Direct lending strategies have offered attractive returns relative to even the riskiest classes of public debt in the extremely low-yield environment post-GFC. These returns are not generated through indiscriminate risk-taking but rather through the ability of direct lending funds to address unmet needs in the lending market through their flexibility, such as by offering bespoke lending terms.

Investors anticipating rate hikes may find comfort in floating rate structures that protect returns from rising rate environments, while carefully structured transaction terms offer high recovery rates in an uncertain economic environment which may see rising defaults. On the flip side, investors must be prepared for the illiquidity of direct lending investments relative to public debt. It is also important to select fund managers with adequate resources and track record of success.

6.  Commodities as a satellite play – Exposure to broad commodities provides inflation protection and diversification

The dual crises of Covid and the Russia-Ukraine crisis have cast the spotlight on commodities and sent prices skyrocketing in the past two years. Beyond short-term price fluctuations, we believe that there are also longer-term tailwinds for commodities:

1. Global fragmentation will continue to drive up price risks – Geopolitical tensions and supply-side disruptions are contributing to increasing protectionism. For example, as countries limiting exports of food, energy, and other staples on the basis of ensuring ‘self-sufficiency’ sets the stage for unpredictability in supply and rising prices.
2. Continued relevance of fossil fuels in medium term – Fossil fuels continue to account for the bulk of global energy consumption despite some progress in the energy transition, since renewables have yet to provide a feasible alternative. A mismatch between the persistence of fossil fuel demand in the medium term and political pressures calling for an immediate halt of investments into this sector supports elevated energy prices.
3. Long-term energy transition is metals intensive – Vast amounts of metals are crucial for the construction of low-carbon infrastructure such as iron ore for wind farms, copper for solar panels, and lithium for battery storage. This demand boom, coupled with prohibitive regulations and chronic underinvestment in metals production due to ESG concerns, is set to see tightening demand-supply dynamics in this area.

Given the robust long-term demand drivers and persistent supply-side challenges facing commodities as whole, we believe broad commodities exposure will offer the following benefits:

1. Inflation protection - As a key component of inflation, commodities help defend a portfolio against the impact of rising prices and have historically performed well during periods of high inflation.
2. Diversification – Sensitivity of commodity markets to non-financial drivers allows commodities to provide diversification benefits to a portfolio of financial assets. Historical performance demonstrates the value of commodities in cushioning against equity downturns.

7.  Content is King – Content owners, advertising-based models and user generated content set to be winners in the content value chain

The term “Content is King” was first coined by Bill Gates in 1996, when he opined that “Content is where I expect much of the real money will be made on the Internet, just as it was in broadcasting.” His words proved prescient.

Indeed, content consumption is an integral part of our everyday lives alongside the usage of smartphone and the internet. In a world where attention span is short, and content platforms are aplenty, good content drives monetisation. In this thematic-focused piece, we deep dive into the music, video, and gaming industries to determine the best opportunities in this extensive value chain, and highlight the following Content Winners:

• Content owners will emerge as clear winners in the industry given their control over extensive content libraries with high monetisation value.
• Advertising-based models will dominate given consumers’ willingness to put up with advertisements to consume content at a lower cost.
• User Generated Content is a business model that enjoys both strong growth potential and low capital outlay requirements.

 
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