Investment Strategies
How Investors Should Read Trade War Clouds
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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.