Cross Asset Strategy
As inflation starts to look persistent and tight labor markets combine with supply disruptions to continue creating upside inflation risks, Developed Market (DM) central banks are beginning to realize they are too far behind the curve. Synchronized inflation feeding into wages, aggressive tightening by the Federal Reserve and other central banks, and a growth slowdown, form the macro backdrop we’re now working with. Taking into account the more hawkish actions, particularly from the Fed, J.P. Morgan Investment Bank now sees it hiking 50bps at both the May and June FOMC meetings, with additional 25bps hikes at each meeting thereafter until March 2023—lifting the midpoint of the Fed target range for the funds rate from 0.375% currently to 2.875% by 1Q23.
In the Private Bank we think this aggressive path will likely lead to a growth slowdown, with recession probabilities rising to approximately 30% over the next 12 months. With that backdrop, we are becoming more cautious in terms of our recommended allocations. We favor late-cycle and defensive sectors in equities – tech, healthcare, and industrials (defense); and adding fixed income through investment grade bonds and Treasuries. In terms of geographic allocation, we still prefer the U.S. despite aggressive hiking – but it’s more of a relative story. Europe has significant headwinds from higher commodity prices and Japan is too cyclical. In Emerging Markets (EM), we’re very selective; preferring commodity exporters and China A-shares but cognizant that a strong dollar and rising food inflation present a challenging backdrop for these markets.
Strategy Question: How do we see the recent moves in FX?
As markets continue to grapple with rising macro uncertainties, moves in the FX market are drawing attention. Apart from the strengthening of commodity currencies consistent with higher commodity prices, central bank divergence has been increasingly shaping the narratives. Over the past weeks, markets continued to re-price central bank moves in the face of elevated inflation. Currencies in countries with hawkish monetary policies outperformed those with more dovish central banks. In particular, the strength of the dollar became a key theme. The DXY has gained +3.3% from January lows amid a sharp rise in front-end yields.
The standout move in FX of late has been the weakness of the Japanese yen (JPY). The yen has weakened by 5-10% against G10 currencies this month, with USD-JPY trading at the highest levels since 2016. The Bank of Japan’s (BoJ) steadfast dovishness has been an outlier across the developed world. It is the only major central bank still determined to keep policy easy and anchor rates near zero. At the last policy meeting (March 28), BoJ Governor Kuroda largely dismissed the currency’s weakness, and the BoJ decided to offer fixed-rate tenders to buy 10-year JGBs potentially at unlimited size. It reinforced expectations that the BOJ would prioritize its yield targets over the exchange rate, and thus interest rate differentials widened further.
With the somewhat synchronized rise in global yields this year, there were some expectations that the BoJ would downsize its stimulus. This is firstly due to the rising costs of food and energy that are causing a backlash from households. Secondly, it is thought that a synchronized DM tightening trajectory will likely give scope for a bit of policy normalization. So while the interest rate backdrop remains JPY-negative, given it has already moved a lot, we only see modest further depreciation from here (with a new outlook range of 120-124).
In terms of monetary policy divergence vs. the U.S., one currency that frequency gets mentioned is the CNH. The People’s Bank of China (PBOC) has been tightening policy since the second half of 2020. Coming into 2022, the central bank is likely to adopt a neutral policy with an easing bias. Bond markets have already been reflecting this divergence for some time. As a result, the interest rate differential between 10yr U.S. Treasuries and 10yr CGBs has now narrowed to 38bps – the smallest since 2018. At the same time, domestic banks’ FX settlement and sales data showed portfolio outflows contributed to USD2.7bn of USD buying (and RMB selling) in February. This is a reversal from January, which saw USD2bn of inflows and 2021, which had a total inflow of USD19.3bn. This suggests that the diverging economic and policy cycle does influence the currency. However, the size of portfolio flows is fairly small relative to trade flows.
In our view, the bigger determining factor for the RMB’s direction this year is China’s current account. The current account consists of trade in goods as well as services (such as tourism). Over the last two years, strong exports and a lack of tourism outflow have lifted the current account surplus to around 2% of GDP. Looking ahead, a meaningful shift in either of the two will likely impact the direction of the RMB much more than changes in relative interest rate differentials. On the trade front, our assumptions are that export and import growth are likely to slow in tandem in 2022 from the elevated levels in 2021, leaving a marginally larger trade balance compared with last year. We also assume China’s COVID policy may not shift this year.
Meanwhile, there are risks that could drive USD-CNH higher. In our view, the risk of export disappointment is one worth watching. In particular, if we were to see a much weaker global growth environment amid high commodity prices, but at the same time aggressive easing in China, which will boost import growth, the trade balance picture could deteriorate.
Taking all these factors in, and against the strong USD backdrop, we think our outlook range for USD-CNH at 6.4-6.6 is still a reasonable reflection of the balance of risks in the months ahead. Despite significant market turbulence so far this year, the RMB has stayed relatively calm. The USD-CNH pair went through some small fluctuations, but is basically unchanged on a year-to-date basis. While the PBOC’s easing bias has not led to outright currency weakness, it has certainly brought down the cost of hedging. This presents an opportunity for investors who want to hedge for a sharp reversal in China’s export performance this year.
So what about the broader Asia region? Year-to-date, regional currencies have been relatively resilient considering the overall strong USD environment. Trade-oriented currencies like the South Korean won (KRW) and Taiwanese dollar (TWD) could trade on the weaker side if global growth worries mount. TWD forward points are still negative, which offers a very cost-efficient way to hedge for investors so inclined. The Singapore dollar (SGD) will likely be on a strengthening path on the back of further Monetary Authority of Singapore (MAS) normalization. While the growth outlook is becoming more clouded, with inflation momentum reaching near decade highs, downside risks brought on by depressed household and business activity (given spikes in food and energy prices) have become the greatest immediate policy concern. We think the MAS could accelerate slope steepening, and potentially carry out an upward re-centering of the nominal effective exchange rate (NEER) midpoint at its April policy meeting.
For equity investors, the recent strengthening of USD-JPY in March has had a positive impact on Japanese equities given the heavy index weighting towards exporters that earn revenues predominantly in USD, and with JPY costs. Historically, it is estimated that Japanese TOPIX index companies collectively experience a positive 0.5-0.7% earnings impact for each 1% strengthening of USD-JPY, and this has translated into a 11-12% rise in the TOPIX since early March. However, we acknowledge that global growth expectations have emerging risks to the downside. With the Japanese index a more cyclically oriented equity market, and Japanese corporates increasingly likely to issue conservative guidance at full year fiscal results, we would look to reduce broader Japanese equity market exposure in the coming weeks.
Regarding some of our currently preferred regions – the stronger USD-TWD is likely to be a net positive for corporate earnings. The index is heavily dominated by semiconductor companies that derive revenues in USD, but the associated cost base is located in Taiwan. We expect that the gross margin pressure that such semiconductor companies have faced over the last two years in Taiwan could see some relief from the recent weakening in the TWD. Meanwhile, the China A-share market is likely to be largely immune to the recent currency movements, as the vast majority of listed companies service the domestic industry and face low foreign exchange risks given revenues and costs are denominated in RMB. Offshore China equities could face a modest headwind, as earnings are translated into Hong Kong dollars (pegged to USD) from RMB.
All market and economic data as of March 31, 2022 and sourced from Bloomberg Finance L.P. and FactSet unless otherwise stated.
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Index definition:
The U.S. Dollar Index (DXY) is an index of the value of the United States dollar relative to a basket of foreign currencies, often referred to as a basket of U.S. trade partners' currencies.
TheTOPIX, also known as the Tokyo Stock Price Index, is a capitalization-weighted index of all companies listed on the First Section of the Tokyo Stock Exchange.
