The blood is being sucked from markets: Here's why dividends and credit can bring your portfolio back to life

“The Federal Reserve is the only Sherrif in town,” says John Woods, Managing Director of Credit Suisse in the Wealth Management Asia Pacific Division.

And what happens when the only Sheriff in town raises rates harder and faster than everyone else? 

Well, currencies chase rates, and that’s especially the case when it’s the US Dollar. 

Woods reckons diversified dividend plays and investment-grade credit are a good place to start.

“If you believe that inflation will peak eventually, and that interest rate hikes will pause eventually and that bond yields will decline eventually, then buying a short duration investment grade bond portfolio is a prudent investment decision,” he said. 

Note: This interview was filmed on 14th October 2022. To access the interview please click on the player or read an edited transcript below.

What are the most important macro themes you’re focused on at the moment and how are they informing your investment strategies?

Three things. Interest rates, interest rates, interest rates. That’s completely dominating the global economy right now, both in terms of fundamentals and also the way the markets are having to respond to them. Essentially, particularly in Asia, we live in a dollar-denominated and dominated world and the Fed raising rates is rather like throwing a stone in a pool. You get this ripple effect. The closer you are to the dollar, the more impacted you are by those ripples. But inevitably every country in the region will be impacted in some way or another.

It’s essentially about the tightening of liquidity, and a higher cost of money. And as I say, that impacts both underlying fundamental economic activity, but it also affects market behaviour as well. 

We are having to absorb and manage the higher cost of the dollar and subsequently a weaker local currency complex. We’re having to see essentially liquidity flow out of markets chasing the stronger dollar and subsequently a weaker performance by the equity indices and of course higher bond yields as well. In the round, taken together, it’s a really complex challenge that the Asia region is facing.

We’ve had 15 years of close to zero interest rates, and now as the Fed is pushing up rates higher, central banks around the region are having also to push up rates higher and that clearly is impacting the performance and price of assets.

Euro-denominated assets aren’t doing well. The US looks like it’s headed for a hard landing. How are things looking in the Asia Pacific region?

Well, these are three great points you are making. I actually think that really the factor that links all three points that you are highlighting is the US dollar because right now the Fed’s the only game in town. It’s the only sheriff in the town and it’s pushing up rates harder and faster than anybody else. And that is doing something called increasing interest rate differentials. It means that the US dollar is a lot more attractive than, for example, the Euro, as you suggested. And it’s also the case that the Eurozone is experiencing its own set of challenges, not least in the price of gas and oil as a consequence of the conflict in Ukraine.

We already think the Eurozone is either in recession or very close to recession. I think it’s slightly more of a debate in the US. I don’t think there’s going to be an all-out recession in the US for at least the next six to nine months, possibly 12. And that’s a function of the very low unemployment rate, still reasonably low leverage amongst corporates, and the underlying health of household balance sheets. So yes, I agree completely. US growth is decelerating sharply. Whether or not it’s in a technical recession or the broader definition of a recession is open to debate. But certainly, the stronger dollar is impacting this part of the world, the Asia Pacific.

It tends to suck the lifeblood out of markets here. 

Investors look at weakening local currencies, they look at the strengthening US dollar and they think I’d rather be in the winning trade. And so they unwind their local currency and buy US dollar-denominated assets. 

And as I mentioned earlier, as well, higher interest rates tend to slow down economic activity. It’s a sad fact of life. The higher rates go, the more costly money becomes, and as a consequence investment slows. We absolutely will be impacted by the higher dollar. But for some countries, particularly those like Australia, which have a robust external account and still have I think a strong engine of growth in resources, I think the impact of these higher rates will be somewhat limited.

Against that backdrop, where are you seeing opportunities in equity and credit markets?

Well, equities are rather a challenge right now given that really the tech sector, for example, which drove equity performance over the last 10-15 years or so, clearly is experiencing something of a reversal. And we’ve seen quite a profound de-rating of the major tech stocks over the last year or so. Actually, we think that the income strategy probably makes the most sense in this rising rate environment. And that’s all about, in particular, defensive dividend stocks.

If you can identify a fund solution or a basket of stocks where the yield is 5-7%, in my mind that makes a lot of sense in terms of a diversified portfolio. 

Absolutely exposure to diversified dividend plays makes a lot of sense. Also, actually, I’m becoming a lot more optimistic and positive towards investment-grade bonds. If you look at investment-grade yields, they’re back to sort of 6.6-5%. We’ve not seen those sorts of levels since the GFC back in 2008. And if, like me, you believe that inflation will peak eventually, that interest rate hikes will pause eventually, and that bond yields will decline eventually, then buying a short-duration investment grade bond portfolio I think is a prudent investment decision. And given that we are forecasting an expected return of around 5% over the next 12 months, again, it is a critical part of a balanced diversified portfolio.

Are the big tech stalwarts now at fair value or are they still overpriced?

I personally think they’re still rich. I still think that although you’re completely right, they have come off a lot over the last six to 12 months. I have to say that they were at excessively priced valuations a year or so ago, and I still think that there’s further price depreciation to come. And the reason is as follows. Generally speaking, the tech stock space is important for two reasons. Obviously, it’s an extraordinarily good way of getting access to disruptive technology and clearly, disruptive technology tends to have fairly wide margins for obvious reasons. But tech also outperformed typically because it didn’t pay a dividend and it was all about price appreciation. And price appreciation works really well in a low interest rate environment.

But now the opposite is happening. We’re having a higher interest rate environment. Clearly, there is no growth in the price of tech. It’s kind of the opposite, it’s falling. And that’s why dividend stocks in general now are outperforming the tech space, largely because they have this sort of inbuilt protective feature in that dividend story which is attractive to investors. And of course, that’s something really that the tech space doesn’t have.

Now that it costs something to take on debt, do you see any way for those big tech names to drive earnings?

Well, I think from an operational perspective, they will simply be doing more of the same. I mean, they’ll be seeking to innovate, they’ll be seeking to disrupt. They will be seeking to introduce products and services which try and provide some innovative edge to the market. Actually, I think their leverage levels in general are extremely low. I mean, these are companies typically that operate with substantial cash piles. And so to that extent from an operating perspective, they’re seriously protected against higher rates given typically low rates of leverage.

But for those which are levered, and I would suggest these are perhaps the early stage midlife cycle tech names, there will be certainly some pressures on debt service. 

For the large names, cherry-picking an entry opportunity is probably the name of the game, but one, I don’t think it’s likely to become apparent until I want to say the first and second quarter or so of next year.

Aside from big tech, which sectors are you underweight at the moment?

Well, I think anything which really underperforms in a rising interest rate environment, those particular growth names, those growth stocks, those growth styles which depend on low growth rates and low inflation rates are those which we are concerned about and typically underweight. There’s some value in looking at retail names which enjoy some pricing power in a higher interest rate environment. And typically these are the consumer luxury stocks that people will buy regardless – consumer staples and discretionary. Those names, again, which people will buy consistently notwithstanding a higher interest rate environment. But beyond that, I think I would be a little bit cautious.

There is some value in financials and we will hear about that I think in the next few days when the US banks report. Typically, banks tend to do well in a rising rates environment because of course they have a higher net interest income. And as the US banks report in the next week or so, we’ll see whether or not that’s been feeding through to that bottom line.

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