The US Federal Reserve’s (Fed) rate hike is nearing its peak, predicts DBS’s chief investment officer (CIO), Hou Wey Fook, in the bank’s CIO insights for 1Q2024. This follows the Fed’s swift series of rate hikes, totalling 525 basis points over 16 months, marking one of the fastest increases in history.
As US rates approach their peak, concerns arise with disinflation setting in and the Fed pausing its monetary tightening. Hou highlights the risks of potential overtightening, compounded by the US’s severe indebtedness and precarious fiscal situation.
While a soft landing for the US economy remains the CIO’s base-case scenario, Hou is expecting to see substantial volatility for risk assets as the three major turning points meet: rising disinflation and peak Fed rates, a negative yield gap on equity earnings and the US 10-year treasuries, and the Fed pause amid a dis-inversion of the yield curve.
CIO’s recommendations
Hou and his team recommend investors put their money into bonds over equities, with a negative yield gap underlying the relative attractiveness of the former.
Furthermore, equities could be “further challenged” as companies see their profits being pressured by the effect of weakening aggregate demand on revenues and margins.
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“Heavily indebted companies with weak balance sheets would be most at risk as they face additional headwinds from higher interest expenses,” says the team.
Should investors still prefer equities, the team has upgraded its view on US stocks to “overweight” as they see further earnings upside due to the market’s tech stocks, which are poised to benefit from a peak in the Fed rates.
“The US has the largest exposure to tech, and this will underpin its outperformance over other major geographies like Japan and Europe,” the team notes.
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Last year was a very good year for US tech stocks. The tech-heavy Nasdaq Composite saw returns of 43% while big tech — or the Magnificent Seven stocks — rose a whopping 96%.
The Magnificent Seven, which has somewhat expanded from the original Faang stocks (for Facebook, Amazon, Apple, Netflix and Google), refers to the mega-cap stocks Apple, Alphabet (previously Google), Microsoft, Amazon, Meta Platforms (formerly Facebook), Tesla and Nvidia.
Among equities, the team also favours quality growth in the technology, communications and consumer discretionary sectors, as well as Asia for deep value.
“In our portfolios, we would have upsized positions or in high-quality great companies in these three sectors here — technology, communications and consumer discretionary — for the growth end of our barbell portfolio,” says Hou.
Artificial intelligence (AI) stocks, which have seen outsized returns in the past year, is also still a sector the team views positively.
“Despite the spectacular run in the stock prices of AI companies, we remain at the early innings of AI adoption,” says Hou. “AI will increasingly be more pervasive, more entrenched in the global economy. AI is also a game-changer. While it will clearly increase worker productivity… it will also level the playing field posing existential risks to established companies.”
“Now as a result, IT spending will be a multi-year trend as corporates are fearful of disruption or even obsolescence from competitors that may even include start-up companies. The ecosystem of AI will grow beyond semiconductors, really the brains behind empowering AI towards cloud, towards software services, cybersecurity and automation,” he adds.
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Investment-grade bonds still preferred; gold in ‘sweet spot’
Within the bond space, the team recommends investors remain with investment-grade bonds rated “A” or “BBB” in credit in the three- to five-year duration space.
“Having done 525 bps of rate hikes, we expect bond returns to be certainly less bumpy going ahead,” says Hou. “In a multi-asset portfolio, the consistent income from holding bonds would really mitigate any spike in volatility that comes from the holdings in equities.”
“So really, it’s a good time to invest. You are actually locking in pretty nice yields going forward,” he adds.
However, the team notes that investors should remain cautious with credit risks as they can accumulate even after a peak in rates. And should a recession hit along with a “blow-up” in yield spreads, non-investment-grade companies or issues will encounter difficulty refinancing their matured bonds leading to escalating defaults in the high-yield segment bond market, Hou points out.
The three- to five-year segment is in a “sweet spot” where front-end yields remain higher than the historical averages, while longer-term yields could see more upside risk from mean reversion. The team also sees bright spots in additional tier 1 bank capital instruments, quality emerging-markets credit and local currency bonds that would benefit from moderating strength in the US dollar.
Gold is also in a “sweet spot” with peaking Fed rates and the current geopolitical uncertainties. As such, the team has upgraded gold to “overweight”, allowing further upside for the asset. “Broader concerns over the US’ debt burden and fiscal sustainability will only add to gold’s attractiveness as concerns of de-dollarisation gain traction,” the team says.
