Keiko Kondo, head of Asia multi-asset investments at Schroders, has data supporting the notion that we are approaching a higher than average chance of the US economy ending in a recession. Her model confirmed 20 indicators examining inflationary, monetary and short-term macro and financial market trends.
“At the end of April, nine of these indicators mark recession risks. Two-thirds of inflationary measures, which are barometers for early recession warning, signal recession risks. In the coming months, monetary variables are the ones to be seen when the Fed tightens. monetary policy, ”she notes.
What are the imminent risks of a recession?
Inflation indicators have longer lead times, which means that it typically takes more than 12 months for a recession to occur. Kondo notes that historically, when recession indicators go up above a 45% level, the recession risk becomes imminent. There were seven cases where at least 45% of the indicators point to a recession in the last 32 years, and five of these cases were in the middle of a recession if not led to one.
“When we think about [the economic outlook] in scenarios, it is very difficult for us to come up with events that fall under ‘reflational’ and ‘productivity boost’ brackets. “In her analysis, scenarios such as inflation on the supply side, a downside in the war between Russia and Ukraine, rolling shutdowns in China and consumer recession end in ‘stagflationary‘or’ deflationary ‘results.
Is Asia Isolated from a US Recession?
A contagion of recession risks from the US and Europe to the rest of the world seems inevitable. Some of the Asian economies that could be more susceptible to these risks would be trade-heavy South Korea and Taiwan. However, portfolio managers believe that a large part of Asia stands to be in better shape.
Looking at the broader Asian economy, Thomas Poullaouec, head of APAC multi-asset solutions at T. Rowe Price, takes a larger part of China’s influence with it. “Asia is very sensitive to China, where we are not talking about interest rate hikes, but a further policy solution and support. The country is likely to be one of the first global economies to accelerate again from the downturn that could ease the effects of the downturn in the new Asia. “
Which raises the question – is China a hedge?
Can China serve as a hedge?
Schroders’ Kondo and Matt Wacher, Chief Investment Officer for Asia Pacific at Morningstar Investment Management, also see the value in investing in a turnaround in China’s technology.
Sydney-based Wacher finds the sector attractive due to the valuations and the safety margin available there after the deep corrections over the past few years. “There is a reasonable position for Chinese technology in our portfolio. And as some of the regulatory risk decreases, we would probably add that position,” he says. “At this point, the only thing preventing him from adding to his positions is in China tech, the uncertainty surrounding the changes to the rules, both domestically and from abroad, where for example the US regulators are looking for the incompatible Chinese ADR listings on the US stock exchanges, for example.
He continued: “If we were to get clarity on more of those things, we would definitely see the sector as a good option. Such as Alibaba (BABY) and Tencent (TCHEY) is very focused on China. They offer the rest of the portfolio an exposure that has different drivers, so we see these stocks as quite isolated from a US recession. “
Kondo, which manages the bronze-rated Schroder China Asset Income Fund and Neutral-rated Asian Asset Income Fund, believes China is a market in the world where the company will not shy away from owning more growth stocks. The reasons behind a stock market correction in China were not directly linked to higher interest rates in the US, but political initiatives. Although volatility may persist, Kondo believes that growth stocks in the offshore China area will see a much greater upside potential.
If not China, where else can one find security in a recessionary environment?
Another market Kondo likes is Japanese stocks, which she describes as ‘under-owned and unloved’ by investors. “Japan is among very few markets where politicians welcome inflation. Thus, headwinds from the central bank would be less noticeable,” explains Kondo, who calls the country ‘breaking the deflationary thinking’. The macro environment supports Japanese companies as a weaker yen should boost profits from trade exports.
Higher interest rates do not provide an opportunity to maintain current stock multiples and also raise questions about future growth prospects. As a result, markets have recovered – US equities fell 21.8% year-on-date. Using the Morningstar US Market Index as a proxy, these were no worse periods from January to June than this. To add to the general gloom, the US 10-year government bond fell by 14.1% year-to-date, marking its worst six-month run in history.
Poullaouec believes that a key question is whether the increase has come stock / bond correlations seen in early 2022 was just temporary or reflected a structural regime change that could keep correlations high for an extended period of time.
“If the latter explanation is correct, alternatives to the traditional 60/40 stock / bond allocation, which include dynamic hedging and other defensive strategies, may provide benefits for some investors,” he says.
In equities, he has added his holdings of real assets-related equities, brought the position to overweight, to ensure hedging if inflationary pressures continue longer, or settle higher than expected. For the interest rate portion, he increased his exposure to Asian credit as its interest rate spread is the widest it has been in 10 years.
Kondo turns more to gold as diversification compared to bonds and commodities, as the latter have stretched valuations and come with a volatile nature. “Gold tends to do well in the early stages of a tightening cycle where we are.” While she aggressively avoids buying bonds, which she believes are reasonably valued now, gold offers a way to hedge the recession risk. Agricultural-related stocks are also a way to capture the inflationary benefits while avoiding the difficulties of gaining direct access to the commodities market.