Quarterly Outlook
Fixed Income Outlook: Bonds Hit Reset. A New Equilibrium Emerges
Althea Spinozzi
Head of Fixed Income Strategy
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Equity Monthly: Can EM shares find their footing?
Peter Garnry
Chief Investment Strategist
Last month’s Equity Monthly focused on China setting up the premise of its own centrality to world affairs. But while China is destined to become the world’s largest economy, the country is currently experiencing a slowdown due the US-imposed tariffs and a general weakening of the massive, post-2015 impulse that has swept the Chinese economy forward for more than two years.
Among the latest fragments of evidence for a weaker China was the worse-than-expected Q2 technology earnings season, which saw many of the country's tech giants expand heavily into new businesses to secure top line growth at the expense of profit margins. Today, Chinese carmakers tumbled around 5% as Great Wall Motor announced an aggressive pricing campaign to maintain market share as the Chinese auto market has retreated to its slowest rate of expansion since early 2012. Growth has barely been above zero over the past 12 months and competition is increasing. This will likely hurt operating margins, and it could be the story that clings to Chinese equities over the coming quarters.
The current regime is a puzzling one. The Federal Reserve’s policy normalisation and Trump’s trade war is a benefit, at least in financial markets, to US equities at the expense of everyone else (see the trade war ETF basket chart below). Looking at economic forecasts for the G10 countries, only the US' has been raised while all others have headed lower. Our view is that US outperformance can continue for a bit longer, but a major swing is getting closer.
EM is decoupling in Fed’s rate normalisation
For the first time since 2008 we are experiencing a decoupling between developed and emerging market countries and equities. The two blocs have moved in tandem over the past decade with EM showing more downside volatility, but the direction has been synchronised. In 2018, the direction has inverted, as shown in the chart below. In our view, this is a sign that Fed’s monetary tightening is beginning to have an impact on the weakest link of the global economy: countries with structural current account deficits.
The Fed is confident enough to pursue an additional two interest rate hikes this year, but 2019 looks increasingly troublesome. On top of Fed normalisation, President Trump’s trade policy is strengthening the USD and adding further pressure on EM. Deep cracks have opened in countries such as Turkey, Argentina, South Africa, Brazil, and China. As a policy responsem China has added stimulus through the fiscal and monetary channels on top of recently announced automatic stabilisers (as seen in Europe). These moves will counter some of the effects and eventually change China's fortunes.
For the first time since 2008 we are experiencing a decoupling between developed and emerging market countries and equities. The two blocs have moved in tandem over the past decade with EM showing more downside volatility, but the direction has been synchronised. In 2018, the direction has inverted, as shown in the chart below. In our view, this is a sign that Fed’s monetary tightening is beginning to have an impact on the weakest link of the global economy: countries with structural current account deficits.
The Fed is confident enough to pursue an additional two interest rate hikes this year, but 2019 looks increasingly troublesome. On top of Fed normalisation, President Trump’s trade policy is strengthening the USD and adding further pressure on EM. Deep cracks have opened in countries such as Turkey, Argentina, South Africa, Brazil, and China. As a policy responsem China has added stimulus through the fiscal and monetary channels on top of recently announced automatic stabilisers (as seen in Europe). These moves will counter some of the effects and eventually change China's fortunes.
It is our view that investors should slowly begin adding exposure to EM even though the timing may be too early. In an August 10 Trade View, we presented the case for EM – essentially China, India, South Korea, and Taiwan – as both fundamentals and technical (mean reversion) suggest an interesting setup for being long EM equities and short US equities. As said, the timing could be too early; Trump may announce an additional $200bn in tariffs on Chinese goods, for instance, but the majority of the impact from this move is likely priced in.
The bar is set so low that the slightest upside surprise on trade will likely push Chinese/EM equities higher by 5%
Stay defensive, keep technology
Our message on equity positioning remains as it was in August. We favour the two defensive sectors, health care and consumer staples, while continuing to also favour technology stocks (up 6.5% in August, measured in USD). Health care and consumer staples have low interest rate sensitivity and have a historical tendency to offer downside protection in cases of increased volatility. The technology sector has increasingly become more defensive because of very low interest rate sensitivity., but most importantly it still has the best upside potential in growth terms.
The bar is set so low that the slightest upside surprise on trade will likely push Chinese/EM equities higher by 5%
Stay defensive, keep technology
Our message on equity positioning remains as it was in August. We favour the two defensive sectors, health care and consumer staples, while continuing to also favour technology stocks (up 6.5% in August, measured in USD). Health care and consumer staples have low interest rate sensitivity and have a historical tendency to offer downside protection in cases of increased volatility. The technology sector has increasingly become more defensive because of very low interest rate sensitivity., but most importantly it still has the best upside potential in growth terms.
On our daily Morning Calls, we have pushed the idea that European equities should strategically be underweighted as the continent’s equity market has few catalysts. Europe is export-driven and thus vulnerable to current trends of nationalism and protectionism. In addition, the two largest sectors in global equities, technology and financials, are either non-existent for the former and very weak for the latter, making European equities less attractive.
European equities are only interesting as a tactical bet when there is a positive change in the global economy due to their large exposure to materials and industrials.
Overweight equities versus bonds
With a global recession still at least 12 months out on the horizon based on the current available data, equities should still be overweighted versus bonds. Global equities are still not expensive in outright terms (see chart below) given earnings growth and global economic activity. The global bond market is still not offering an attractive alternative to equities as a yield component in any portfolio. Previously, bonds could offer both return and diversification during stressful periods; now, the yield component is gone but bonds should still be used to hence downside diversification.
Even US bonds remain unattractive for foreign investors as the interest rate differential is eaten up by currency hedging unless non-US investors want to assume the USD risk, but with the trade-weighted USD trading 13% above the historical average since 2006, it seems like a risky proposition.
European equities are only interesting as a tactical bet when there is a positive change in the global economy due to their large exposure to materials and industrials.
Overweight equities versus bonds
With a global recession still at least 12 months out on the horizon based on the current available data, equities should still be overweighted versus bonds. Global equities are still not expensive in outright terms (see chart below) given earnings growth and global economic activity. The global bond market is still not offering an attractive alternative to equities as a yield component in any portfolio. Previously, bonds could offer both return and diversification during stressful periods; now, the yield component is gone but bonds should still be used to hence downside diversification.
Even US bonds remain unattractive for foreign investors as the interest rate differential is eaten up by currency hedging unless non-US investors want to assume the USD risk, but with the trade-weighted USD trading 13% above the historical average since 2006, it seems like a risky proposition.
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