During an investment conference, Mr Tharman Shanmugaratnam, Senior Minister and Chairman of the Monetary Authority of Singapore coined the term, “the perfect long storm”, to describe the present uncertainty and fragility that the world is facing1.

We see the risk of fast rising interest rates which could tip us into a recession. And they are in response to the high and persistent inflation which had been exacerbated by the ongoing war that resulted in energy, grain and other commodity shortages.

Even more importantly, it’s to put in place a strategy which positions our portfolio 2 – 3 steps ahead of what we think could be happening.

 

Signs of recession

Like in other aspects of life, the economy and the stock market also work in cycles. While we look at various indicators to gauge the current economic season, two salient ones are the yield curve and Composite Leading Indicator (CLI). These are leading indicators which signal when the next recession, Winter, could be near. Currently, they both indicate that the season remains as Autumn but also signal that economic headwinds have been increasing.

The chart above shows the difference between the 10-year US treasury yield rate and the 2-year US treasury yield rate. This particular treasury spread that “approaches” 0 signifies a "flattening" yield curve. A negative 10-2 yield spread has historically been viewed as a precursor to a recessionary period2” except for once during the 1960s – see Chart 2 below.

On top of that, the CLI, which “is designed to provide early signals of turning points in business cycles showing fluctuation of the economic activity around its long term potential level3” is also trending downwards. This is an aggregate of the business cycles of 47 major countries and regions globally.

Even though not all the downtrends (represented by the red line) preceded a recession (shown by the blue bars above), it showed that the economic activities had slowed. The previous substantial downtrend came about due to COVID-19 in 2020, and yet the world did not see a recession, which is defined as two consecutive quarters of declining GDP. This was due to massive monetary and fiscal policies by the respective governments, which buoyed the economies and even the stock markets.

 

Possible Scenarios

In the earlier part of the year, we had proposed that there are two likely scenarios in the near-term:

1.As the US Fed is frontloading monetary tightening for the first “half” of the year, Fed would ease interest rate hikes as inflationary pressures abate in the second “half”.

2.The interest rate hikes would inadvertently tip the economy into a recession.

 

We now think that the 2nd scenario has a higher possibility as inflation would remain persistent.

Is it an opportunity or an adversity?

We could see this as an adversity or an opportunity – it all depends on our mental model.

The “external economy” of booms and busts can give a reference, but it does not rattle the “internal economy” of preparedness, and a winning mental model. That is, making value, instead of price, your bedfellows.

 

Price vs Value

Imagine that you had been investing in the following company, and it drops 30% with the COVID-19 crisis, wiping out almost all the gains in the past few years.

For many of us, when a stock we’ve bought drops 30%, we might be lamenting the fact that our funds could be better deployed somewhere else. However, this is also when we are too fixated on the short-term gyrations and price of the particular stock.

For Unicorn, we walk the talk in terms of value investing, and prefer to look into the fundamentals of companies instead of what might be trendy at a particular point in time.

Operating earnings are part of the fundamentals that we look at. And stock prices tend to follow the company’s value, ie. its operating earnings, over the long term.

Chart 6 showed that Company A’s value had increased 5.4 times since 2011. Let’s a take a look at its stock price below:

Similarly, as you can see from its stock price, it has increased by about 6 times, moving in tandem with its value. And you can also see from the above chart that the 30% dip was simply a blip in its upward trajectory.

Most of us would gladly keep this company in our portfolio after understanding the fundamentals and knowing the value of the company, which is actually Google.

Portfolio Approach

Our portfolio is actively managed with the current allocation: 40% Equities, 20% Gold and 40% Cash as we believe that this allocation gives us the resilience to take on the current volatility that’s brought upon us by the uncertainty and fragility.

Besides that, we are also looking into asset classes such as long-term government bonds and high quality growth stocks which could assist us in navigating the slowdown as well as a possible recession successfully.

The current discount of the stock market is reflective of the uncertainties of the economy and the market. However, these discounts will probably disappear in time when relative certainty returns to the market. Do strategise soon with your Unicorn Financial Consultant.

Sources:

1.Monetary Authority of Singapore

2.Y Charts

3.Organisation for Economic Cooperation and Development (OECD)

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