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How Investors Should Read Trade War Clouds

Fahad Kamal, 19 June 2019

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The chief market strategist of the UK private bank sets out the firm's asset allocation views.

Fahad Kamal, chief market strategist at UK-based Kleinwort Hambros, the private bank, talks about rising protectionism and worries over how a reversal to globalisation will affect investment. The editors at this news service are pleased to share these views but don't necessarily endorse all opinions of guest writers. Email the editor at tom.burroughes@wealthbriefing.com or  jackie.bennion@clearviewpublishing.com

 

A mild correction
 The US decision to raise tariffs to 25 per cent on $200 billion worth of Chinese imports caught investors off guard; markets had been expecting a trade deal before the summer. Acerbic rhetoric and the US's decision to blacklist Huawei – a major Chinese tech player – have further soured the relationship. US President Trump’s decision has come as growth was beginning to stabilise in the eurozone and in China. Additional tariffs are bound to take their toll on trade volumes, which will weigh on manufacturing activity, capex plans and business sentiment. According to manufacturing surveys, hiring in the sector could slow, dragging private consumption – the main pillar of global growth – in its wake.

Nonetheless, our base case scenario still hinges on a trade deal by year-end, though admittedly the risk of a more adverse outcome has increased. Solid macro data and better-than-expected earnings have provided support in the storm. Moreover, China is likely to increase stimulus measures to mitigate the impact of US tariffs. The Federal Reserve (Fed) may also intervene to prop up growth if needed. Indeed, equity market reaction has been rather moderate so far, with less than a 5 per cent drawdown in the US; this sort of volatility is typical for the asset class.

We remain sanguine on equities given reasonable global valuations, still largely positive momentum and neutral sentiment. We also have allocations to investment grade bonds, High yield credit and emerging market debt. Nonetheless, prudence is critical, particularly in this stage of the cycle. Last month, we increased duration in our government bond holdings – going from short to neutral – in spite of uncomfortable valuations. While yields have fortuitously fallen further over May and early June, we continue to believe that government bonds offer poor value in absolute terms. Indeed, they continue to be critical in offsetting risks from equities and other risky assets, similar to our positions in gold and low volatility alternative strategies.

Lower for longer
Since early 2019, 10-year UST [US Treasury] yields have declined steadily, falling below 2.1 per cent in early June. Fed caution – given muted inflation and trade war anxiety – has supported safe-haven assets. Investors now expect between two and three US rate cuts by year-end, and some Fed members have warned that patience would remain key for “some time.” Our view remains that interest rates should stay anchored, with yields unlikely to hit 3 per cent again over the next 12 months; inflation remains the critical swing factor, but the trade war is far from over, giving plenty of impetus for safe havens.

German bond yields well into negative territory
The 10-year German bond yield is well into negative territory (- 0.20 per cent) and macro data remains stubbornly weak, led by manufacturing confidence surveys mired in contractionary territory. The political picture is hardly brighter, with Italian budget insubordination compounding an insalubrious Brexit atmosphere. In this gloom, the European Central Bank kept interest rates unchanged at its June meeting. The big picture remains bleak: even the kitchen sink of monetary policy has not resulted in the ECB bringing inflation to normalcy, or growth to bloom. Indeed, core Eurozone bond yields remain unattractive, yet a rally in late May/early June speaks to their efficacy as safe havens even at these levels.

Defaults likely to remain low
Since early May, downward pressure on oil prices and risk aversion have pushed the yield differential (or “spread”) between UST and corporate bonds (i.e. “credit”) wider by some 40bp. The current level is 100bp above the 2018 average. Default rates are expected to stay low, and stable corporate bond issuance bodes well for US HY [high yield debt]. Based on Fed policy projections and spread forecasts, HY remains more attractive than IG. In the eurozone, spreads have widened slightly too. However, there is no sign of tighter financial conditions at this stage. Here again, default rates should remain below historical averages. Lower issuance this year, compared with last, should cap spreads around current levels. The hunt for yield will encourage investors to prefer corporate bonds to sovereigns.

Brexit uncertainty heightens
May’s resignation starts the succession race and investors are braced for a hard-line Brexiteer. Yet, none of the drama in Westminster appears to be deterring investors from holding gilts as safe havens. On the contrary, gilts have rallied over May and early June – yields have dropped from above 1.2 per cent to about 0.8 per cent - along with US Treasuries. We recently increased duration in government bond holdings in most portfolios from short to neutral, largely to mitigate equity risk in multi-asset portfolios.

Equities: Mixed picture leads to little regional conviction, renewed trade tensions revive uncertainties

US
The US market should remain supported by the Federal Reserve’s dovish stance, easier financial conditions and improving earnings in coming quarters. S&P 500 earnings pers share (EPS) growth decelerated from 12.6 per cent YoY in Q4 2018 to 1.4 per cent in Q1. Weak Q1 earnings were much better than feared, outstripping estimates by 6 per cent. Most encouragingly, EPS revisions have turned positive. Going forward, profits should be supported by resilient sales growth on the back of solid domestic demand. Indeed, US companies generate a majority of top-line revenues in their home market. However, EPS recovery should be capped by downward pressure on margins, as wages rise and higher import tariffs push input costs higher. Overall, low visibility on US-China trade negotiations and high valuations warrant a neutral stance.

UK
The market offers high dividends and attractive valuations but is penalised by the uncertain Brexit outcome. Britain’s largest companies are sensitive to swings in sterling given their significant share of overseas revenues. Furthermore, the market could be penalised by lower Brent prices (see overleaf) due to its high exposure to commodity-related sectors (some 28 per cent of FTSE 100 market capitalisation).

Eurozone
After a weak H2 2018, the medium-term economic outlook should improve thanks to fiscal easing and more ECB support. This cyclical market should also benefit from any stabilisation in the Chinese economy in coming quarters. EPS revisions have turned positive and profit growth is expected to recover gradually. However, this recovery is jeopardised by renewed US-China trade tensions. Even if the US decides to wait another six months before implementing higher tariffs on car imports, uncertainty could weigh on the auto sector till then. Despite attractive valuations – notably compared with the US on 12- month forward P/E – and high dividends, we remain neutral.

Japan
Despite attractive valuations, this cyclical market is highly sensitive to global trade (notably, for large caps) and the uncertainty created by the possible levy of US tariffs on car imports. In addition, the outlook for EPS growth and domestic demand are both weak ahead of the VAT hike scheduled this October. A potentially stronger yen (due to its safe-haven status) is also a headwind due to its negative correlation with the equity market.

Emerging markets
The unexpected trade and tech war escalation is an additional headwind for EM equities with no quick fix in sight. We expect intensifying Chinese stimulus and US dollar weakness to help mitigate the impact of higher tariffs. Meanwhile, rising risks to global growth could keep central banks dovish and foster further fiscal easing. However, markets may be too complacent about a rapid trade resolution. We remain neutral on emerging markets, with a view to upgrade should trade risks start to recede.

Currencies: expect further dollar resilience
By mid-May, optimism had grown on prospects for a US-China trade agreement, lower odds of a “no-deal” Brexit and greater clarity on auto tariffs. Now however, the uncertainties could last another six months, with negative implications for capex, exports and manufacturing. Continued monetary and fiscal support will be critical to sustain global growth and market liquidity.

The dollar and, to some extent, the yen are likely to show resilience, boosted by safe-haven flows. However, expectations for Fed rate cuts have also escalated, leaving a range-bound outlook. Downward pressure on the euro could persist, plagued by Brexit, Italian fiscal slippage and the threat of US auto tariffs. The picture is slightly different for EM currencies – movements will depend on each country’s exposure to global trade. Room for further CNY weakness looks limited, with a drop beyond 7 CNY to 1 USD not expected.

General elections in the UK?
Prime Minister May’s resignation will trigger a Conservative Party leadership contest, which will likely choose a hard-Brexiteer. This would reduce the odds of a deal in Parliament which supports a soft Brexit. A successful no-confidence vote in the new PM could lead to a general election. While a soft Brexit remains our base case, we cannot rule out “no-deal”, which would cap any GBP upside. We maintain a $1.32 target.

Geopolitics versus trade: conflicting oil drivers
Oil supply could shrink by nearly 1mb/d following the unexpected cancellation of waivers on Iranian crude, rising risks of civil war in Libya, and deepening crisis in Venezuela. Crude oil spare capacity remains ample, but OPEC+ are unlikely to fully offset supply disruption with higher output, as happened in 2018. While shale producers will probably lift output, a geopolitical premium could underpin oil prices. We expect Brent will rebound to trade in a $70-75 range.

Uncertainty premium for gold
Fundamentals – global economic resilience, muted inflation pressure and dollar strength – are not particularly supportive for gold. However, enhanced policy uncertainty and geopolitical risks are both helpful. Indeed, gold broke through $1,300 in early June.

Hedge funds: Overweight, but be selective
Hedge funds can help in unstable market conditions, but selectivity is key. We prefer strategies which hold their own in bear markets, such as merger arbitrage. These strategies provide relatively safe, uncorrelated sources of returns from equities, our most significant allocation across balanced and growth multi-asset strategies. These investments have been a positive contributor of returns – and lowered risk – especially during a volatile Q4 2018.

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