Quality Shines Through
Pivot to quality plays bearing fruit. Faced with rising recession risks, sticky inflation, and corporate margin compression, we advised investors to stick with high quality equities at the start of t...
Chief Investment Office - Hong Kong19 Apr 2023
  • Our strategy focused on high quality equities is bearing fruit as the segment outperformed by 6.6% pts YTD
  • Expect the flight to quality to persist as portfolio allocators navigate twin macro headwinds of earnings and economic slowdown
  • Smaller companies without the benefits of economies of scale will face headwinds from higher cost of capital, as the era of cheap money comes to an end
  • Flight to quality has translated to sharp disparity in performance; Technology and Financials registered respective outperformance of 26.0% and 23.5% YTD over their respective small-cap peers
  • Maintain our strategy of sticking to quality plays across equities and bonds given attractive risk-reward
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Pivot to quality plays bearing fruit. Faced with rising recession risks, sticky inflation, and corporate margin compression, we advised investors to stick with high quality equities at the start of the year. Our strategy is bearing fruit. Quality plays (as proxied by S&P 500 Quality index) has outperformed US small caps by 6.6% pts year-to-date (YTD) and we expect this momentum to continue as portfolio allocators are confronted with the following macro headwinds in the coming months: 

  • US earnings recession is on the rise with earnings forecast deteriorating further to
    -3.7% y/y in Mar-23 (vs. -1.5% in Feb-23 and average of +18.9% y/y in 2022).
  • US ISM manufacturing fell further into contractionary territory at 46.3 in Mar-23 (vs. 47.7 in Feb-23 and average of 53.5 in 2022); a sub-50 reading suggests that manufacturing activities are in contraction mode.
  • According to Bloomberg Economics, the probability of a US recession over the next six months has surged from 11.5% in Dec-22 to 99.9% in Feb-23.

The persistence of macro challenges is expected to underpin the “flight to quality”, thus translating to broad bifurcation in performance across sectors.

The Haves & the Have-nots: Bifurcating sectoral performance as era of cheap money comes to an end. As the Fed keeps monetary policy tight and the cost of capital stays elevated, smaller companies without the benefits of economies of scale will face substantial challenges in navigating an environment where the era of cheap money has come to an end. The market recognises the new reality and this explains the disparity in performance between quality plays and smaller caps in the Technology and Financials space:

  • US Technology: US technology quality plays (as proxied by NYSE FANG+) rallied 35.6% YTD and this translates to an outperformance of 26.0% pts over US small-cap technology plays (as proxied by Russell 2000 Technology).
  • US Financials: US financials quality plays (as proxied by S&P 500 Banks) fell 7.4% YTD and this translates to an outperformance of 23.5% pts YTD over US small-cap banking plays which plunged 30.9% (as proxied by S&P 500 Regional Banks).

Bottom-up anecdotal evidence reinforces our view. Despite the fiasco ravaging smaller regional banks in the US, it is however an oasis of calm among the larger quality banks and the ongoing earnings season attests to this. For instance:

  • Citigroup (C US): Citigroup reported EPS of USD2.19 in 1Q23 and the exclusion of divestment gains from its India consumer business translates to an EPS of USD1.86 – both of which are higher than Bloomberg consensus forecast of USD1.645. Rising rates boosted net interest income (NII) across the board while the US Personal banking segment also registered strong loan growth.
  • JP Morgan (JPM US): JP Morgan reported EPS of USD4.1 in 1Q23 (vs. Bloomberg consensus of USD3.345). NII soared on the back of higher rates.

Stick to quality across equities and bonds. The acute pullback in financial markets last year has thrown up fresh opportunities across the risk spectrum. But we maintain our strategy of sticking to quality plays across equities and bonds given attractive risk-reward in this space.

 

Figure 1: Quality tech outperformance

Source: Bloomberg, DBS

 

Figure 2: Quality banks outperformance



Source: Bloomberg, DBS

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