More sources of uncertainty

Houseview | Week 33 2019

Highlights

    • Latest US tariff announcement for China triggers market jitters
    • Increasing unrest in Hong Kong and Kashmir heightens risk of intervention
    • Brexit, Italy and Argentina cloud the political outlook in Europe and further afield
    • More defensive positioning; overweight in US Treasuries pays off as markets tumble
    • China allows renminbi to weaken to offset tariff impact and send a warning to the US

While the trigger for the current financial market nervousness was President Trump’s 1 August announcement that the US would impose tariffs on the remaining Chinese imports that had not yet been targeted, other crises and uncertainties have played an increasingly important role in the recent sell-off.

When several key negatives come together, a market correction tends to gain momentum and this is what seems to be happening now. The US-China trade conflict remains the big negative, with more and more long-term uncertainty clearly having a major impact on business confidence, capital expenditure and overall growth rates. Data in Europe and Asia in particular continue to be weak.

Meanwhile, the situation in Hong Kong is a growing source of further uncertainty, with the intensifying protests and risk of a military intervention by the Chinese authorities. No less worrying is the situation in Kashmir, where the Indian government retracted regional autonomy, triggering local protests and heightening tension between India and Pakistan, and creating a renewed risk of military confrontation between the two nuclear-weapon-equipped neighbours.

Political risks could further impact a Europe already reeling from trade issues

In Europe, the risk of a no-deal Brexit continues to increase, with the European leadership unwilling to renegotiate the deal struck with former Prime Minister May and with the new PM, Boris Johnson, showing little appetite for compromise. Italy too has returned to the forefront of the political arena. While the Brexit deadline of 31 October rapidly approaches, investors will also have to deal with the prospect of early Italian elections. Both Brexit and the prospects of a more assertive government in Rome are likely to put more pressure on a Eurozone economy that is already being hit by the global trade uncertainty.

And then suddenly, last Sunday, a new problem emerged, when the unexpectedly large defeat of President Mauricio Macri in Argentina’s primary elections caused the country’s asset markets to suffer a severe correction. The prospects of a policy U-turn in Buenos Aires, away from the IMF-supported reform programme and back to the old-style Peronist populism, with expansionist economic policies, capital controls and a high likelihood of another sovereign default, could lead to more nervousness in emerging markets in the coming months.

Despite all these risks and uncertainties, global equity markets have only corrected by 6% from their all-time high on 26 July. This can be explained by the strong commitment of central banks to ease monetary policy enough to prevent a recession. It remains to be seen whether the Fed and ECB will be able to deliver the stimulus that investors have recently been expecting. But as long as markets do not price out the current expectations of two Fed rate cuts this year and two more in 2020, bond yields are unlikely to rise much and equities will be sustained by relative valuations. The big risk here is that the global economy could still fall in a recession, due to the trade uncertainty and heightened geopolitical risk, and despite the aggressive monetary stimulus. In the end, further central bank easing will not remove the root cause of the economic downturn, i.e. the Trump administration’s America First protectionism.

Defensive positioning pays off as US Treasuries benefit from flight to safety

In our tactical asset allocation, we have made several changes in the past weeks. Before the US tariff announcement on 1 August, we had a modestly defensive positioning, with an underweight in real estate, an overweight in US Treasuries and an overweight in fixed income spreads. On the first day of the correction, we closed our overweight in spreads and opened underweights in both equities and commodities. So far, this defensive positioning has worked reasonably well, with particularly the overweight in US Treasuries paying off. Expectations of weaker economic growth and the flight to safety during the correction of the past weeks have pushed down the US 10-year bond yield from 2.08% to 1.60%.

On a regional level, we reduced our exposure to emerging markets. The only EM position we had on 1 August was an overweight in EM hard currency sovereign debt, and immediately after the tariff announcement we closed this and moved to a small underweight in EM equities. With the pressure on EM business confidence likely to intensify again due to the setback in the US-Chinese trade talks, it is not safe to assume that the improvement in EM growth momentum that took place in June and July will continue. Nor is it likely that yesterday’s news that some of the US tariffs will be delayed will help reduce uncertainty. Also, the most recent Chinese credit data confirms once again that the Chinese authorities remain unwilling to resort to aggressive monetary stimulus to compensate for the manufacturing weakness caused by the trade conflict.

Trump brands China a currency manipulator as renminbi slides

Instead, the government in Beijing has started to allow the renminbi to weaken. This can be seen as a means to partially offset the effect of the US tariffs and to counterbalance their negative impact on China’s market share in the US, but primarily it should be interpreted as a warning sign for the Trump administration. The Chinese government is willing and prepared to respond to new US trade barriers with currency depreciation. A weaker Chinese currency is likely to pull many EM currencies down with it, increasing the likelihood of a stronger US dollar index. A stronger US dollar means tighter financial conditions in the US and headwinds for US growth. President Trump’s quick accusation of China being a currency manipulator should be seen in this light. It should be noted that most of the Chinese authorities’ interference with their exchange rate in the past decade has been with the intention of keeping the currency stronger than it should have been, rather than keeping it artificially weak.

China: capital flows

C.A. deficit + Δ FX reserves, USDbn
Houseview Graph
Source: PBoC, SAFE

Although we expect the Chinese government to respond to possible new US protectionist steps with more currency weakening, we are not too worried that the total depreciation of the trade-weighted renminbi on an annual basis will move to double-digit levels. Beijing still remembers the high levels of capital outflows in 2015 and 2016, particularly after the August 2015 renminbi depreciation (see graph). Since then, capital controls have been tightened, but the authorities know that it will be difficult to contain outflows once people feel the currency faces more downside risk. This is the main reason why we think the Chinese government will remain cautious in using the renminbi as a weapon in the trade conflict. In any case, the simple fact that the Chinese currency has started to move has created more headwinds for EM currencies and is the main reason why we have reduced our overall exposure to emerging markets.

Tactical Asset Allocation
  • Equities
  • German Bunds
  • US Treasuries
  • Fixed Income Spreads
  • Commodities
  • Real Estate
Fixed Income
  • Investment Grade US
  • Investment Grade Eurozone
  • High Yield US
  • High Yield Eurozone
  • EM Hard Currency Sovereigns
  • EM Hard Currency Corporates
  • EM Local Currency Bonds
  • Italy Spread
  • Spain Spread
  • Inflation-linked US
  • Inflation-linked Eurozone
Equity Regions
  • US
  • Eurozone
  • UK
  • Japan
  • Pacific ex-Japan
  • Emerging Markets
Equity Sectors
  • Communication Services
  • Consumer Discretionary
  • Consumer Staples
  • Energy
  • Financials
  • Health Care
  • Industrials
  • Information Technology
  • Materials
  • Utilities
Commodities (only open positions and changes)
  • Brent oil
  • Natural gas
  • Wheat
  • Corn
  • Upgrade
  • Downgrade
  • Overweight
  • Neutral
  • Underweight

Jan Bakkum
Maarten-Jan Bakkum Senior Emerging Markets Strategist

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