In recent times, the global economy has been facing a downward spiral of demand destruction, caused by a duet of higher inflation and interest rates.
Higher inflation is outpacing income, shrinking household budgets and confidence levels, observes PhillipCapital analyst Paul Chew.
Chew explains that for corporates, costlier energy and materials eat into margins and force cutbacks in production. The negative spiral that ensues has workers demanding higher wages and corporates jacking up prices. Aggregate demand is further worsened by rising interest rates, triggering a deflationary shock for asset prices.
“We are in the middle of this downward spiral, where it is hard to short-circuit rising inflation without demand destruction. ” says Chew.
There are silver bullets to lowering inflation but these are of low probability, notes Chew: an end to the Ukraine conflict, lowering of tariffs on goods going from China to the US and higher crude oil production following Biden’s visit to Saudi Arabia.
“The most critical macro call this year will be inflation,” he adds.
The analyst expects inflation to peak by 4QFY2022 ending December, though figures may remain “stubborn”.
“Supply chain conditions are easing, commodity prices are rolling over and capacity is responding to higher commodity prices, albeit cautiously,” Chew writes. “Any sustained rally in equities will also depend on the direction of the Fed’s interest rates.”
“Our base case is rates will rise to a neutral level of 3% by the September Federal Open Market Committee (FOMC) meeting. Thereafter, we expect the Fed to step down on its rate-hike cycle to 25 basis points (bps) or even pause,” he adds.
Chew also believes the Fed will pause to assess economic conditions before resorting to more aggressive moves. “Higher interest rates work with a lag,” the analyst explains.
At the same time, inflation has largely been driven by supply chain constraints and disruptions. “Monetary tools cannot resolve these bottlenecks,” Chew says.
As for the threat of recession, Chew observes that leading indicators point to a weakening economy, raising the probability of a recession in the US.
“Computing probabilities is pointless, however,” says Chew, “a probability of say, 60%, only means the predictors were not wrong, whatever the outcome.”
Meanwhile, economic conditions in Singapore remain resilient. Industrial growth is hovering at 9% this year, slower than last year’s 14% but far stronger than the pre-Covid-19 level of 2%. Foreign direct investments into the country have recovered sharply as well, close to the record levels of 2019. Employment is also surging with record vacancies.
Banks to benefit from higher rates
In his report, Chew continues to remain positive on the banking sector. This is in light of how banks benefit from higher rates through their excess liquidity or float and the repricing of variable loans. As such, benefits immediately flow through to the bottom line.
Weaker macros and inflation will likely lead to modestly higher general provisioning, while staff costs will escalate due to a robust employment market.
“We prefer OCBC for its highest capital ratios, high current account savings account (CASA), exposure to a reopening of China and Hong Kong and dividend upside,” says the analyst.
In addition, Chew believes that softer economic conditions will raise provisions though not significantly. For instance, the bank’s loan growth has been toeing nominal GDP growth, unlike the 2008 and 2016 provisioning cycles when loans outpaced GDP by 2-5% points over two years.
Residential property prices have also been climbing back to double-digit levels not seen since end-2019 and 2011. New launches have sold more than 70% just over a weekend. A dearth of supply with unsold inventories of 14,000 is the lowest in more than a decade and only 1.2 years to sales. “Rising prices work in the favour of developers with planned launches such as City Developments (CDL),” says Chew.
After reversing all the gains chalked up this year, the index was flat in 1HFY2022. Its largest drags were banks, the consumer sector and industrial REITs. Despite rising rates that will benefit banks’ interest margins, recession worries buffeted cyclicals, particularly the banks, notes Chew.
Reopening proxies, including Genting Singapore and SATS, also suffered, he adds. The biggest gainers were helped largely by company-specific factors. Dividends in specie of its financial arm benefitted Yangzijiang Shipping. Stellar earnings at Astra International provided a tailwind for Jardine Cycle and Carriage.
Sembcorp Industries rallied on higher spark spreads in India and Singapore.
Phillip Absolute 10 Portfolio movements
PhillipCapital’s Phillip Absolute 10 Portfolio, which tracks the brokerage’s top 10 picks for absolute returns, underperformed the benchmark Straits Times Index (STI) in 2QFY2022.
The model portfolio was down 3.7% y-o-y, with banking stocks such as DBS and OCBC being the largest drag on the portfolio.
According to Chew, positive contributors to the portfolio were CDL, Keppel Corp, Ascott Residence Trust and HRnetGroup.
For 3QFY2022, it added Singapore Telecommunications (Singtel) and removed Frasers Centrepoint Trust (FCT).
“We find the current dividend yields unattractive as interest rates climb up further,” Chew explains with regards to removing FCT. “We added Singtel due to the return of roaming revenue as borders reopen, economic recovery in emerging markets and potential restructuring or monetization of Bharti and Optus.”
Chew says that PhillipCapital’s mid-cap growth names are Del Monte Pacific and HRnetGroup.