Tariffs cloud business outlook

Protectionist uncertainties to cool business investment plans

May 2019 could be a pivotal point of this economic cycle. U.S. President Donald Trump’s tweet on May 10 announcing an increase in tariffs from 10% to 25% for USD 200billion worth of Chinese exports has significantly dented market optimism that Beijing and Washington could reach a trade deal quickly. The subsequent rise in scrutiny on selected Chinese tech companies by the U.S. government has also escalated tension by several notches. Beijing has since shown a tough stance of “we prefer to negotiate, but we are not afraid to fight if we have to”. The next key event will be the G20 Summit in Osaka on June 28-29, where Chinese President Xi Jinping and President Trump will be in the same place and another summit is possible. While the hope is that the two leaders would come up with another truce similar to the one agreed to in Buenos Aires last November, the economic and market implications are worth considering. Assuming they agree to freeze tariff increases again, the financial markets could react with a cheer.

However, global businesses are likely to be less forgiving. They would be mindful that the 2020 presidential election could increase uncertainties in trade relationships between the U.S. and a number of its key trade partners. President Trump using tariffs as a threat to Mexico to address illegal immigrants is a case in point. This implies that companies could be cautious in making new investments. While gross capital formation is typically around 20%-25% of the global gross domestic product (GDP), this is also the more dynamic part of global growth. Hence, cautious business sentiment would increase the risk of weaker growth, or even recession.

Bond market signals more growth worries

Bond investors continue to reflect their concerns over growth, with the U.S. Treasury (UST) 10-year yield falling below 2.3% for the first time since late 2017. The German 10-year government bond yield fell to its record low on May 31, as investors look for a safe haven amid fear of weaker growth. The U.S. Treasury yield curve inverted again with the 3-month bill yield being higher than the 10-year bond yield. We have argued in the past that investors should interpret the UST yield curve with care given years of quantitative easing by global central banks creating distortions.

However, with business confidence coming under pressure due to trade issues, there is now a clear possible trigger for weaker growth. The month of June could be crucial to observe whether the Trump administration is willing to pull back from some of its tariffs announced. We could also see other governments and central banks do more to support growth.

Central banks coming to the rescue again?

A number of central banks opted to cut rates in May, such as Malaysia, the Philippines and New Zealand. A more balanced Federal Reserve (Fed) has helped to ease currency pressure on emerging market currencies. This provided more room for monetary easing.

The two giants in the room would be the U.S. and China. A number of senior Fed officials are now open to keep policy flexible depending on incoming data. The rate hike bias in 2018 has shifted to a more balanced view, and this led investors to believe that the next move could be a cut. This has been reflected in the futures market since late 2018. The rising trade tension and subsequent decline in business confidence could well force the Fed to do just that. This is despite the fact that U.S. consumption remains in good shape, supported by a strong job market and relatively healthy household balance sheet.

For China, the People’s Bank of China is still mindful not to flood the economy with liquidity and lead to a bigger debt burden to deal with in the future. However, the economic costs from the trade tension would still need to be addressed. Its April economic data was also weaker than expected, showing that the 1Q rebound was short-lived. With tax cuts and government fee reductions only implemented earlier in the year, it could be fiscal spending’s turn to do the heavy lifting.

Investors need more than a firm handshake to cheer again

The 5% correction in MSCI World in May was hardly catastrophic, especially considering the strong gain in the first four months of 2019. The widening of the credit spread in the U.S. corporate debt market was also modest in scale, from a relatively tight level.

For investors to embrace risk assets again, a more cordial relationship between China and the U.S. is needed, but perhaps will not sufficient. This improvement needs to be sustainable and reduce business uncertainties. This still seems like a sensible strategy for President Trump to get re-elected, so we still believe there is a role for equities to play in asset allocation. This is particularly true if we consider the low earnings expectations across the world for 2019, and how U.S. companies have outperformed in 1Q 2019. Earnings per share (EPS) growth reached 4.5%, or 6.8% excluding energy, and 75% of companies beat earnings estimates.

Asian corporate earnings may take longer to recover given the delay in trade cycle improvement. The focus here would be the domestic demand story, especially with the rise in the middle class in large markets, such as China, India, Indonesia and broader southeast Asia. Possible supply chain diversification from China to other parts of Asia would benefit these markets too.

The low yield environment is likely to push more investors toward income-generating assets, such as corporate debt and emerging market fixed income. Relatively low default rates also help. Risk aversion has supported the U.S. dollar and Japanese yen. What has been a surprise is the lack of direction in gold, which traditionally is well supported in falling real yield environment.

Global economy:

• U.S.-China trade tensions returned to investors’ focus as President Trump announced raising tariffs on USD 200billion of exports from 10% to 25%, as well as scrutinizing more Chinese tech companies’ business in the U.S. and their business relationships with U.S. companies. He also announced the introduction of a 5% tariff on all exports from Mexico beginning June 10 due to illegal immigration issues.
• Trade tension is raising investors’ fear of rising risk of recession in the U.S. and weaker growth globally. The Federal Reserve is content with current policy rates, but could cut rates if economic data weakens. Meanwhile, central banks in Asia, including Malaysia, the Philippines and New Zealand, have cut rates as currency pressure eases. (GTMA P. 28, 19)

Equities:

• The return of trade tension has put pressure on global equities. The S&P 500 and Euro Stoxx 50 were down 5% in May. This correction came despite the fact that U.S. 1Q corporate earnings were stronger than expected. EPS growth reached 4.5%, or 6.8% excluding energy, and 75% of companies beat earning estimates. (GTMA P. 32, 41)
• In Asia, the CSI 300 lost 6.8% in May and H-shares in Hong Kong were down 9.5%. Other export-oriented economies, such as South Korea, Taiwan and Singapore, saw heavier losses due to escalating trade tension. Thailand, Malaysia and the Philippines have shown greater resilience. Indian equities, on the back of PM Modi maintaining BJP’s majority in the parliament, have gained as investors appreciate political stability. (GTMA P. 32, 39)

Fixed income:

• Growth worries, partly due to escalating trade tension, pushed U.S. Treasury yields lower by 32bps in May. The 10-year yield fell below 2.2%, the lowest since late 2017. The spread between the 3-month T bill and 10-year yield has inverted again. The same trend is observed around other developed markets. The German Bund 10-year yield was 18bps lower in the month and returned to negative yield.
  (GTMA P. 45, 49)
• U.S. high yield debt experienced a modest widening of credit spread (60bps) in May as growth fears returned. This was partly offset by falling risk-free rates. For emerging markets, quality prevailed with investment-grade sovereign and corporate debt generating a modest positive return, while high yield was under pressure from spread widening. (GTMA P. 51, 52, 53)

Other assets:

• Concerns over weaker demand beat geopolitical uncertainties and potential supply disruptions in Iran and Venezuela. The price of West Texas Intermediate oil fell by 8% in May to below USD 60pb. Gold failed to take advantage of the latest bout of risk aversion and decline in real yields. The price of gold is still capped below USD 1,300/oz. (GTMA P. 61, 62)
• The USD index gained 0.7% in May despite falling UST yields. The euro suffered with falling local interest rates, but risk aversion has helped to boost demand for Japanese yen. For Asia, a key focus has been the weakening of the Chinese yuan and whether it will depreciate beyond the psychologically important level of 7 to a USD. Officials from the People’s Bank of China have reinforced the message that they would prefer currency stability. (GTMA P. 58, 59)