Q4: Time for Patience, Not Complacency

• 70% chance of recession in 2023, Chief Investment Office (CIO) says
• US Federal Reserve intent on crushing domestic inflationary pressures, but it comes at a cost
•  Stick with quality. Investment grade fixed income is an area our CIO has identified for the current environment
• Watch for clues from China’s party congress meeting for Beijing’s 2023 direction

The US Federal Reserve seems determined to crush inflation by raising interest rates at never-before-seen levels but the costs of doing so will be considerable. Equities and bonds losses in Q2 reduced US household net income by US$6 trillion, with the Q3 damage still yet to be determined at the time of print. The Fed determination is likely to send the US – and possibly the global economy – into a recession next year.

Citi is now looking at a 70% chance of a recession in the United States next year. This is up from 50% mid-year.

Given the above macroeconomic backdrop, there are two areas Citi is looking at.

The first is on yield quality. Citi’s Chief Investment Office believes the priority should be capital preservation and to look to high-quality fixed income in portfolios. Short-duration US investment grade fixed income opportunities now yield between 5% and 7% across various market segments. Among the assets investors may consider are US Treasuries, investment grade bonds, municipal bonds and notes, and preferred securities. Overall, US bond yields now exceeds US equity dividend yields.

This continues our ongoing “Bonds are Back” theme from earlier in the year.

For equities that provide quality yield, consistent dividend growers have historically posted long-term outperformance, except in boom times. This outperformance also come alongside lower levels of volatility. But on the equity side, our macro-outlook suggests the next six months of equity returns remain highly uncertain, and dividend growers may provide the income with the possibility of long-term outperformance.

Sectors with defensive factors like global pharmaceuticals and IT software are included in our “dividend growers” basket. These sectors are less cyclical in nature as consumers and businesses rely on them for their everyday usage.

On the equities side, our macro-outlook suggests that the next six months of equity returns remain highly uncertain, though we do not expect a severe collapse in markets akin to the 2007-08 period. For the time being, we believe there can be better risk/reward in strategies that can shield principal loss while generating income. With the market pricing an elevated cost for buying protection out over the next year or two, this creates potential opportunities for suitable investors to earn a fixed coupon or use those funds to strategically accumulate positions in equities if dips occur. Of course, there are downside risks including loss of principal or changes to issuer credit quality, which should be understood before considering any strategy.

While the rest of the world expects the coming year to be in a recession, China presents a different story.

The second area Citi’s CIO is looking at in the longer-term (6-12 months) is China. China is the sole large economy that is easing monetary and fiscal policy, seeing rising growth, and presenting historically low equity valuations. This is likely to continue in 2023. The numerous policy delays and geopolitical issues represent key risks but isn’t likely to change the direction of its economic trajectory.

On the policy side, there are signs that acute political risks surrounding China are subsiding. These are not completely resolved but are steps in the right direction. For some segments of the market, revisions have turned outright positive. For example, among the 10 largest offshore-listed internet companies, the consensus 12-month forward EPS estimates have risen by 7% from the nadir reached in May, seemingly outpacing the progress made in the equities space.

Its industrial production, retail sales and fixed-asset investments all grew faster than expected in August while its unemployment rates declined. The property sector continues to weaken but that suggests that more stimulus is likely to come after the upcoming National Party Congress.

On the equities side, our macro-outlook suggests that the next six months of equity returns remain highly uncertain, though we do not expect a severe collapse in markets akin to the 2007-08 period. For the time being, we believe there can be better risk/reward in strategies that can shield principal loss while generating income. With the market pricing an elevated cost for buying protection out over the next year or two, this creates potential opportunities for suitable investors to earn a fixed coupon or use those funds to strategically accumulate positions in equities if dips occur. Of course, there are downside risks including loss of principal or changes to issuer credit quality, which should be understood before considering any strategy.

CIO forecasts that China’s real GDP will grow by 4.5% in 2023. This estimate exceeds the estimated consensus GDP forecasts of the US (0.7%) while the EU (-0.5%) and the UK (-0.2%) are expected to contract. Overall, CIO forecasts the global economy to grow 1.7% in 2023, down from 2.7% it forecasted in the middle of the year.

Looking beyond these indicators, here are five signs the OCIS would be looking for to solidify the China recovery story.

1. Policy Support, both fiscal and monetary, to become clearer and stronger as a new political economy cycle begins.
2. A potential end to the pandemic seclusion.
3. Further support to the property sector to restore sentiment and demand.
4. Accommodative monetary policy, that contrasts to developed countries.
5. Low valuations and improvement in earnings will continue to support equities.

In closing, Citi believes markets will remain volatile into the year-end with a “bottom” becoming visible by the end of 2023. Our analysts remain defensive in the near-term and, at the same time, are looking for opportunities to build positions in sectors that could become oversold.