Manulife Investment Management – 2024 Q2 Asset Class Outlook

Japan equities¹ rose 2% over the quarter in JPY terms, but declined 1% in USD terms. The yen continued to weaken over the quarter as the Bank of Japan maintained its loose monetary policy stance while US treasury yields rose higher. Markets globally were affected by both rising bond yields and concerns over China’s economic outlook putting the brakes on strong performances in the first half of the year.

Japan remains the outlier in global markets for maintaining its loose monetary policy, but with rising inflation rates (over 4% for core CPI, excluding energy and fresh food), we believe that the Bank of Japan will come under increasing pressure to begin the process of normalizing monetary policy. In July, the Bank of Japan made a tentative move by raising its yield curve control on 10 year JGBs from 0.5% to 1.0%, but markets were initially unconvinced about its intention to take any further action this year. Since then, the 10 year yield has slowly risen from 0.4% to 0.8% and the Bank of Japan may be moving closer to remove negative interest rates at the short end. This scenario is positive for Japanese financials, which outperformed over the quarter.

With price increases now becoming more commonplace in Japan after decades of deflation, it is more important than ever to focus on companies which have strong pricing power and are able to raise prices in this inflationary environment. Our strategy’s focus on companies with a history of strong pricing power and efficient allocation of capital should provide a platform for outperformance in the current environment. Recent examples of pricing power amongst the portfolio’s holdings include increase in subscription pricing in a Japanese multinational conglomerate corporation’s Entertainment Business, strong demand for a Japanese drugstore chain’s private label cosmetics and large price increases in garage doors and factory shutters in a Japanese shutter & door manufacturer’s US business.

Another leg to Japan’s equity market recovery has been its increasing focus on more efficient use of capital and in many cases, this has meant a significant improvement in shareholder returns, especially in the form of share buybacks. The strategy is focused on finding companies whose management are willing to return excess capital to shareholders when potential returns on new investments do not exceed their cost of capital. For instance, a leading Japanese life insurance company has recently begun its second large share buyback program, which has proven to be a support to the share price over the quarter.

Japan remains one of the cheapest developed markets trading on a price to earnings (PE) multiple that is 25% cheaper than S&P500 (based on Bloomberg consensus for 2023). The weak yen will support earnings growth in 2023, which will help to support valuations. We continue to see improvements in Japan’s ROE driven by improving capital efficiency, which we see as a further catalyst for the market to outperform its global peers over time.

1 Bloomberg, Japan equities represented by TOPIX Index. 

Equity Dividend strategies have a reputation for providing attractive long-term risk-adjusted returns due to their defensive advantages below, which may be particularly well-suited to the prevailing global economic environment of slowing growth, elevated inflation, and higher interest rates.

• Superior long-term returns with lower drawdown in down markets: Over the last 20 years, companies that have initiated or consistently grown their dividends (‘Dividend Growers’) have comfortably outperformed the broader global index, companies with stable dividend payout without growth (‘No Change Dividend Payers’), companies without paying dividend (‘Non-Dividend Payers’) and companies that have cut or eliminated dividends (‘Dividend Cutters’).
  
  Indeed, the ability to pay dividends regularly, and to grow dividends, has widely been seen as an indicator of reliable earnings quality and growth. In more challenging economic environment, equity investors tend to prefer stocks with increased certainty of dividend payments (which are inherently less risky and volatile than capital gains), and those with up-front cashflows, which offer valuable downside protection due to significantly lower drawdowns in down-market periods.
• Lower volatility: Annualized return volatility of Dividend Growers is distinctly lower than that of Non-Dividend Payers and Dividend Cutters.
  
• Inflation-protected income: Income from equity dividends has advantages compared to coupons from bonds. Albeit with more risk, equities typically offer greater upside potential from price appreciation. Besides, unlike bonds and other investments with a fixed coupon, companies could increase their dividend payments over time. As such, companies that increase dividends in inflationary environments can potentially provide inflation-hedged income opportunities.
  
•  Diversification: The abundance of dividends across sectors means there is also ample scope for diversification. The global equities market is especially well diversified across sectors and more so than some regional markets, which supports the case for a global approach to dividend investing.
  

In summary, we believe the long-term case for dividend growth-focused investing in global equities is empirically well-grounded. Such an approach may appeal especially to equity investors, but with a greater degree of built-in resilience. However, from a more tactical perspective too, we believe that today’s economic backdrop (of high inflation, higher interest rates and weaker growth) appears well-suited to a dividend growth-focused strategy in global equities.

Important information

Source: abrdn, Factset. Data from 31/12/2002 to 31/12/2022. Historical compounded returns (%) of dividend categories and standard deviation (%). The investment universe is the MSCI All Country World Index, using annual income class returns. Dividend policy constituents are calculated on a rolling 12-month basis and are rebalanced annually. Category returns are calculated on a monthly basis. Index returns do not reflect any management fees, transaction costs or expenses. Indices are unmanaged and cannot be invested in directly.

For illustrative purposes only. Past performance is not indicative of future returns.

Dividend policy categorisation explanation: The ‘Dividend Growers’ category represents performance for companies which either increased or initiated dividend distributions. The ‘No Change Dividend Payers’ category represents performance for companies which pay a dividend but have neither increased nor decreased their dividend distribution. The ‘Dividend Cutters’ category represents performance for companies which have either cut or eliminated their dividend distribution.

Global Equities Market is represented by the MSCI All Country World Index. Source: MSCI AC World Index factsheet, March 2023

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US Treasury yield continued its upward trajectory in Q3 2023 as economic data came in stronger than expected, including robust consumer spending figures and a resilient labor market. The benchmark 10-year government bond yield ended the quarter at 4.57%, the highest level since 2007¹.

US fixed income markets were under pressure due to the rising yield in Q3 with US HY Corp being the exception, as they benefited from the strong economic data. Preferreds declined alongside broad bond markets during the quarter but remained outperforming US IG Corp and US Treasury on a year-to-date basis¹.

We maintain a favorable view of preferred securities as significantly improved yields should lead to attractive forward returns. Ability to select securities from a broader credit universe and across the capital structure will help navigate the softening landscape and focus on risk-adjusted returns.

The investment team continues their defensive position stance since 2019. In addition, the strategy has positioned for a rising yield environment and remained underweight duration compared to the preferred market², meaning the strategy was relatively less sensitive to interest rates.

With an average investment grade credit rating of BBB- and about 90% of issuers being rated as investment grade², preferred securities are relatively high-quality assets and subject to less credit risks compared to HY Corp. We believe preferreds are well positioned to help buffer any economic slowdown, apart from providing income potential and interest rate risk mitigation.

1 Bloomberg, as of 30 September 2023. Preferreds are represented by ICE BofA US All Capital Securities Index; US HY Corp are represented by ICE BofA US High Yield Index; US IG Corp are represented by ICE BofA US Corporate Index; US Treasury are represented by ICE BofA US Treasury & Agency Index. For illustrative purposes only. Past performance is not an indication of future results.

2 Bloomberg, Manulife Investment Management, as of 30 September 2023. Preferred securities are represented by ICE BofA US All Capital Securities Index. For illustrative purposes only. Past performance is not indicative of future performance. 

We believe economic growth in many Asian markets will remain resilient in 2023 as the recovery from COVID-19 continues. Performance in Asia high yield may be uneven with differentiation in fundamentals likely to continue, highlighting the importance of active credit selection. We continue to maintain a focus on a high quality and diversified portfolio, and choose to not stretch for yields.

We are constructive on the Macao gaming and India renewable energy sectors due to recovery and policy tailwinds, but we have lesser allocations to select financial sectors in Asia due to unfavorable relative valuations. We are seeing pockets of opportunities in the India renewable energy sector, which benefits from India’s strong power demand growth, favorable regulatory environment, cost competitiveness, and ESG tailwinds.

China’s slowing growth momentum and weak property market create downside risks. We are maintaining a cautious and selective stance towards the China property sector. While their valuations are attractive, the continued volatility, funding challenges, and weaker fundamentals are potential risks. We are focusing on developers with adequate internal resources or ability to obtain alternative funding channels to address liquidity needs. One key challenge facing the sector is how to revive sentiment for the property market. An overall improvement in income expectations and property easing is needed to stabilize the property market. We continue to be underweight the China banking sector, partly due to relatively tight valuations, and are finding better value in other global banks.

Asia credit valuations remain attractive, but there could potentially be more volatility ahead. With a current spread over Treasuries (SOT) of 1023bps, Asia high yield continues to trade relatively wide with a 611bps and 542bps premium over U.S. and global high yield respectively. Technicals remain supportive as we expect negative net financing for 2023 amid flush onshore liquidity.

Source: PIMCO, as of 30 September 2023.

All investments contain risk and may lose value. This material contains the current opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product.

PIMCO Asia Limited is licensed by the Securities and Futures Commission. | No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO is a trademark of Allianz Asset Management of America LLC in the United States and throughout the world. ©2023, PIMCO.

The current tightening cycle in advanced economies is already the most aggressive in decades and central banks are continuing down their path of rate hikes, albeit we believe we are close to Fed peak rates. Hawkish language suggests the possibility of further hikes remain on the table, even as ramifications for the global economy continue to unfold. Key to central bank decision making is the persistence of inflation, which has shown signs of moderation but remains too high relative to their stated goals. There is two-sided and substantial risk around central bank outlooks, and the slow improvement in inflation injects a non-negligeable risk of continued further tightening that we feel is underappreciated in markets. Bond yields continue to push higher on the Fed factor, and due to higher oil prices, which could lead to an uptick in inflation towards year end.

Our framework for the Fed outlook remains intact with our forecasts having a 5.5% peak Fed Funds rate. Our base case is that most central banks are now either finished or close to completing their rate hike cycle, though action remains desynchronized. Pockets of resilient macro is prolonging a pivot from the Fed to ease. We remain confident that we get a deterioration in growth. We are forecasting recessionary conditions to envelop much of the globe albeit we believe the recession has been postponed rather than cancelled, with expectations of continued near-term market volatility. Continued tight financial conditions, slowing manufacturing production, a negative consumer wealth effect, and ongoing fiscal drags are all important headwinds to growth. However, the exact timeline for this decline is unknown given now-positive real wages, continued full employment, residual benefits from fiscal stimulus and residential construction could all provide support to GDP for a few more quarters. Against that backdrop, we see material risks around the timeline for when the Fed might cut, which would leave the Fed at peak policy rates for longer than our base case would suggest.

In markets, an uncertain macroeconomic landscape is a potential headwind for equities. That said, corporate earnings have remained strong, outpacing expectations. Given the uncertainty surrounding several factors—among them monetary policy, corporate earnings, geopolitical tensions, and recessionary risks—we are focusing on quality across equity assets and taking a more defensive position. At the same time, we appreciate the excitement surrounding AI and the magnitude of its potential impacts on revenue monetization, productivity, and cost cutting, and seek pockets of related growth opportunities.

High yield bonds and loans, and spread sectors more broadly, have continued to benefit from comparatively high levels of carry and current yield from a historical basis, and from positive investor sentiment and spread levels that have moved tighter year-to-date.

Companies of lower credit quality will have to carefully navigate worsening conditions compounded by increased required rates of return by financial markets. We have seen new issue activity pickup in the latter half of the third quarter, but from very weak levels recorded earlier in the year and in 2022. Default rates have also picked up, particularly for CCC rated issuers, and we believe this trend will likely continue, driven by a potentially weakening economy, a growing number of bonds maturing over the next few years, and restrictive refinancing rates facing many corporations.

Against this backdrop, the importance of security selection and differentiation among spread sector allocations and capital structures is at a premium as is preserving capital and limiting permanent capital losses due to defaults. Despite these challenges, we maintain a favorable medium-term view of the High Yield asset class and spread sectors more broadly as high absolute yields should help provide a buffer in the event that spreads do begin to widen. Having the ability to select securities from a broad credit universe and the flexibility to allocate across fixed income sectors and up and down the credit spectrum should also help with navigating a potentially softer economic landscape.

Tactical positioning will be more prevalent again into end of 2023, to be able to nimbly add and de-risk portfolios as well as add to yield opportunities as they arise. Overall, we are tilted towards higher for longer rates whilst seeing yields keeping contained given the potential for macro data disappointments. The portfolio aims to maintain a consistent payout with alongside a stable NAV, via asset allocation decisions and positioning aimed at mitigating some of the current headwinds.

Rising interest rates continued to weigh on markets in September with both risky and safe haven assets selling off. The Federal Reserve remained on hold at their September meeting, yet most voting members penciled in one additional rate hike in 2023 with markets also adjusting to reflect this potential reality in recent weeks. Similarly, rate cuts in 2024 have been pushed back as investors price in a higher for longer rate environment. Even though inflation has continued to moderate in the U.S. and Europe, rising oil prices, heavier treasury supply, and potential monetary policy changes in Japan have all been catalysts for rising bond yields. The result has been a challenged backdrop for both stocks and bonds since the end of July. Within equities, real estate and utilities sectors have been among the worst performers, while the energy sector has rallied. Across fixed income, duration sensitive sectors have struggled as the 10-year treasury yield hit its highest level since 2007. Conversely, credit fixed income sectors have continued to outperform, notably floating rate exposures that have benefited from higher coupons and limited duration risk.

Our base case remains that the U.S. economy will continue to moderate but avoid a hard landing scenario due to the relative health of consumers and corporates. A further drop in inflation should allow real income to rise across U.S. consumers, further supporting U.S. economic resiliency in our view. Additionally, we expect the job market to remain tight as evidenced by total nonfarm payrolls coming in significantly above expectations last month with upward adjustments in the prior two months as well.  That said, we expect central banks to maintain a higher for longer stance as inflation is likely to stay above target for the foreseeable future. As we’ve seen in the last two months, higher rates can add significant volatility in markets and may impact the economic growth outlook should we see a further move up. Added uncertainty from conflict in the Middle East and the potential for higher oil prices means investors need to proceed with some caution.

In terms of recent positioning, we’ve taken steps to rotate away from high yield after it performed strongly in Q3 versus equities, choosing to own more to covered calls to take advantage of higher volatility and investment grade bonds to capitalize on higher yields from up-in-quality sectors. Overall, we remain measured in our approach given surging sovereign yields and the risk of a policy misstep.