Businesses need more than a handshake

A truce is nice, but businesses are still skeptical

Newton’s third law of motion states that for every action there is an equal and opposite reaction. While economics and markets are sadly nowhere as precise as the world of physics, this law is useful for investors to consider recent developments in world trade and the reaction function of central banks. Instead of reacting to the improvement in the U.S.-China trade relationship, central banks are still going to react to potential downside risks to growth. 

At the end of June, the much anticipated Osaka G20 summit between U.S. President Donald Trump and Chinese President Xi Jinping yielded a largely expected outcome. The U.S. will stop implementing new tariffs against Chinese exports, and both sides will return to negotiations. Some of the bans on U.S. companies selling their products to Chinese technology companies are also eased. This feels like déjà vu of the G20 Summit in Buenos Aires last November when the two sides called a truce and resumed negotiations. 

Preventing an escalation in the trade war between the two largest economies in the world is good news. Combined with the prospects of a 25bps rate cut by the U.S. Federal Reserve (Fed) as early as its July 28-29 meeting, risk assets should have plenty to cheer about. Indeed, we saw global equities rebound in June, as the Federal Open Market Committee (FOMC) Summary of Economic Projections showed more FOMC members are leaning toward rate cuts in H2 2019. 10-year U.S. Treasury yields also fell below 2% in June for the first time since September 2016.

The Fed should react to softer data

Can a less hostile trade relationship between China and the U.S. persuade the Fed to be less dovish? After all, its reaction should be proportional to the threat of an economic downturn. This is where the reality becomes tricky. While financial markets may cheer a resumption of trade talks between these two economic giants, businesses are less forgiving. 

President Trump has now established a track record of using trade policy to achieve non-economic objectives. The threat of tariffs toward Mexican exports to address illegal immigration is a case in point. The fact that such threats were raised after the U.S., Mexico and Canada have signed (but not ratified) the USMCA trade agreement shows that even an eventual agreement between the U.S. and China does not guarantee peace. 

Economic data from the U.S. has shown that companies are becoming more cautious, and corporate investment is suffering as a result. The same applies to Asian companies. The much needed recovery in the global trade cycle is delayed. Under this environment, it makes sense for the Fed to stay cautious and react to economic data, rather than the White House’s policy direction. This would help to maintain U.S. economic growth at a steady path, but room for upside surprises is likely to be very limited. 

This implies Asian investors should remain focused on managing market volatility, even as progress on trade and more dovish central banks are likely to boost short-term market sentiment.

In the medium term, risk assets are likely to be driven by the cross currents of concerns over weaker growth and the limited toolbox of central banks and governments to reflate their economies, especially in the developed markets. This would call for a greater emphasis on fixed income.

The environment of limited upside risk growth and a more dovish Fed would benefit income-generating assets, such as global high yield corporate bonds and selected EM debt. High dividend equities can also benefit from the hunt for yields, especially those in sectors that are less sensitive toward the economic cycles. 

Global economy:

• U.S.-China trade tension eased again with the two presidents agreeing to return to negotiations. Tariffs on Chinese exports will not be raised. It remains to be seen how businesses will react to such news and reflect on their business investment plans. (GTMA P. 17, 19, 20)
• The Fed kept its policy rate unchanged in June, but its updated projection shows 8 out of the 17 FOMC participants expect 1-2 rate cuts before the end of 2019. Fed Chairman Jerome Powell also mentioned that many members currently forecasting no change are also leaning toward easing. The market is now expecting a 25bps rate cut at the July FOMC meeting. Meanwhile, the call for more easing by the European Central Bank is also getting louder due to low inflation, with officials emphasizing the central bank’s readiness to act. (GTMA P. 23, 30)

Equities:

• More dovish central banks and a truce in the U.S.-China trade war helped to boost equity market sentiment across the board. The S&P 500 and Euro Stoxx 600 were up 7% in June. The next key event will be U.S. companies’ 2Q earnings reports. The MSCI EM was up 6.3%, led by China. (GTMA P. 33, 35)
• In Asia, the CSI 300 was up 8.4% in June due to easing trade tensions and more economic support from Beijing. Other bright spots are Singapore and Thailand, both of which rose more than 9% in U.S. dollar terms in the month. However, Taiwan and South Korea only saw a modest uptick in their markets of 3%-4%. This is likely due to the dampened outlook on consumer electronics. Following the post-election surge, the Indian equity market was largely flat in June. (GTMA P. 39-41)

Fixed income:

• A more dovish Fed helped to drive the U.S. Treasury yields lower more than the good news on negotiations resuming between the U.S. and China. The U.S. Treasury 10-year yield fell below 2% briefly for the first time since September 2016. This helped to drive returns across the fixed income asset class. (GTMA P. 45, 47)
• Demand for high income debt is boosted by the prospects of cash return remaining low for an extended period of time. U.S. high yield debt saw its credit spread narrowed by 40bps, compared with the 18 bps of spread narrowing for investment grade. Yet the fall in risk-free rates was the key driver in delivering 2%-2.5% return for high yield and investment grade corporate bonds in June. June was also a positive month for emerging market (EM) debt given a softer U.S. dollar and reduced threat of higher U.S. dollar interest rates. Hard currency EM debt returned 3.4% for sovereign bonds and 2.2% for corporate bonds.
  (GTMA P. 52, 54, 55)

Other assets:

• The price of oil (West Texas Intermediate) rose 9.3% in June as geopolitics in the Middle East, especially Iran and military activities around the Strait of Hormuz, trumped fear of weaker demand. For Organization of Petroleum Exporting Countries and Russia, their focus is on the downside risk to growth and they agreed to reduce production for another 9 months until March 2020 in order to support oil prices. Gold finally performed with falling real yields and a softer U.S. dollar, and broke above USD 1400/oz for the first time since 2013. (GTMA P. 64, 65)
• The USD index dropped 1.7% in June as the Fed is seen to be pushing rates lower and undermining the U.S. dollar’s carry advantage versus other currencies. EM currencies were the biggest beneficiaries, especially those with a weaker current account position and high interest rates. These include the Turkish lira, South African rand and most of the Latam currencies. The Chinese yuan gained 0.8% in June despite fear of it breaking below 7 against the U.S. dollar. (GTMA P. 61, 62)