img 2812 - Market Outlook-May1019

Market Outlook-May1019

What does this mean for investors?

Global equities and other riskier assets fell amid renewed trade tensions. Emerging Market stocks and bonds underperformed.

Equities: What lessons can we draw from 2018’s trade tensions?

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Fallout from the September 2018 tariff hike suggests Asia ex- Japan is likely to be impacted more than the US initially. However, other factors, such as bond yields, monetary and fiscal policies and oil prices, are also important in driving equity performance. This year, a dovish shift among global central banks and China’s fiscal stimulus are likely to be particularly supportive for Asia ex-Japan equities.

The last time the US announced a 10% tariff on USD 200bn of Chinese imports on 17 September 2018, US and Asia ex-Japan equity markets rose 1% and 2%, respectively, in the following week as investors believed an agreement could be reached. However, a month later, US and Asia ex-Japan equities were down 3% and 6%, respectively.

In the US, the materials and real estate sectors fared the worst, while the healthcare and utilities sectors were the best performers in the one-month period. Rising US bond yields were likely a key factor behind real estate sector’s underperformance, despite its usually defensive nature.

In Asia ex-Japan, the real estate and consumer discretionary sectors fared worst in the one-month period, while communication services and energy (usually seen as cyclical sector) outperformed, the latter aided by an oil price rebound.

Bonds: What is the impact of trade tensions on EM bonds?

Higher US tariff is likely to hurt risk sentiment near term. Over the past week, yield premiums on Emerging Market (EM) USD government bonds rose, hurting returns, while EM local currency bonds suffered from FX weakness. Should tensions escalate, EM bond yield premiums could rise further. However, a dovish Fed, reasonable valuations and attractive yields lead us to believe EM USD government bonds are still likely to outperform global bonds over the next 6-12 months.

Asian USD bonds have been relatively stable despite the trade tensions and rising onshore defaults in China. While we acknowledge the risks from these factors, we believe the recent easing in China’s policy stance towards deleveraging should help prevent any spill-over to the USD-denominated bond market.

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FX: Can the GBP break free of Brexit?

Positive Brexit outcome likely to trigger GBP/USD rally. GBP/USD remains in the 1.2870-1.3170 range. Our medium-term expectation for a positive Brexit outcome remains unchanged. Therefore, we expect buying interest to support any dip towards the 1.2770-1.2870 region. A break of resistance around 1.3170- 1.3230 could signal that the GBP breakout is underway, targeting the previous high of 1.3385 and beyond. European parliamentary elections in the UK on 23 May could be a significant indicator of the electorate’s desire for Brexit (or Bremain), which could finally help move the process towards a conclusion.

What is the outlook for ZAR after the elections? The scale of ANC’s victory is key. USD/ZAR could move back towards 14.00 if the ANC wins more than 63% share of vote, while a share below 57% and a strong performance by the radical EFF party could see a test of the 14.75 March high. Also, rating reviews could be brought forward in the event of policy surprises post elections.

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Q1. What are the implications of the recent increase in trade tensions?

We see two key scenarios emerging from renewed US-China trade tensions, which the US has emphasised is due to China backtracking on previous commitments:

1) China retaliates aggressively

2) China negotiates

In Scenario 1, China and the US trade tit-for-tat measures, which would be damaging for the global economy and equity market sentiment. Trade wars are damaging economically through 3 main channels: i) higher inflation reduces consumers’ purchasing power; ii) heightened uncertainty reduces businesses’ incentive to invest; and 3) productivity is undermined, leading to reduced wealth generation, at least in aggregate. Therefore, higher the trade tariffs go and the longer uncertainty extends, the more economic damage trade tensions will inflict and more investors will worry.

The good news is this does not appear to be a central scenario at this stage. China’s decision to proceed with trade talks this week with the country’s lead negotiator, Vice Premier Liu He, included in the delegation is a positive sign, in our assessment. Therefore, for now at least, China appears committed to Scenario 2 (i.e. continued negotiation). While this is unlikely to be a smooth process, it does suggest that the fallout for equity markets may be relatively limited.

For the US S&P500 index, Scenario 2 implies that key support around 2,720 is likely to hold (5.3% below the current level), whereas under Scenario 1, a retest of December lows should not be ruled out (18% below the current level). One thing that makes us less concerned is we believe that the US President, to some extent, uses the stock market as an indicator of whether his policies are successful or not. Therefore, should the market fall below 2,720, then we believe it increases the probability of President Trump becoming more conciliatory.

For the MSCI China index, the equivalent levels are around 3.5% and 15% lower from 9 May’s close. While the US President is clearly less interested in supporting the Chinese stock market, we have seen the authorities ease monetary and fiscal policy significantly in the past 12 months. Indeed, the easing of liquidity conditions for small- and medium-sized banks in the past week suggests authorities are sensitive to any perceived threat of trade tensions to the local economy. More such measures are likely, which could help to limit the downside to China’s equities, at least to some extent.

Our short-term bullish USD-CNH trade, published just before Trump’s tweet, has clearly benefited from increased trade tensions. Scenario 1 would suggest a break of the psychological level of 7 could not be ruled out, whereas Scenario 2 would suggest gains may be unlikely to extend dramatically from here.

Don’t forget the big picture

One final point worthy of note is that, while trade tensions between the US and China have been the most severe, the US is taking an aggressive stance with all of its major trading partners. Therefore, should the US-China trade negotiations proceed and a deal be reached before the June G20 summit, it is likely that the US’s trade focus would shift elsewhere, with Europe and Japan potentially in the firing line. As such, trade tensions of some sort are likely to sustain for the remainder of the year, with the geographical focus and the US’s negotiating stance being the main variables.