OCBC OneWealth App– In the mood for risk

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In the mood for risk

15 July 2019

Strong recovery in June, after a dismal May

Risk assets came back with a vengeance in June to offset most of the losses incurred in May, triggered by the re-emergence of US-China trade tensions. Remarkably, US market benchmarks have made a V-shaped recovery, to sit close to or even hit above 2018 peaks.

Risk sentiment in June was mostly supported by dovish central bank rhetoric. Slowing growth, weak inflation and escalating US-China trade tensions led almost all major central banks to err on the side of caution. Meanwhile, hopes of a US-China trade truce had firmed ahead of the G-20 summit, supporting risk sentiment somewhat.

Trade truce at G-20

Given the supportive outcome of the Trump-Xi meeting on the side-lines of the G-20 summit, we’re left with the question of whether the market can head higher from this point. Market direction will likely be determined by three factors: (1) the global growth outlook, (2) US-China trade risks, and (3) the Federal Reserve’s interest rate path.

From the outset, a trade truce is not a resolution. As was the case in December last year, the US and China have called for a temporary ceasefire. New tariffs on US$300 billion worth of Chinese imports will be postponed, Huawei gets temporary relief from the export blacklist and negotiations will restart in earnest. We’ve seen this movie before. Essentially, there has been no meaningful progress towards a deal. It’s only hitting a pause button on planned retaliations.

And while a truce offers the market some breathing room and may support risk sentiment in the near-term, we should not overlook the lessons of recent history. The path to a deal is likely to be long, winding and rocky. Until a final agreement is inked and the integrity of the global supply chain is not threatened, trade policy uncertainty will remain elevated. As it stands, such crosscurrents have crimped business investments, dampened manufacturing sentiment and weighed on global growth prospects. The good news is, in the face of such negative developments, central banks seem ready to pull the trigger on some pre-emptive easing.

Policy easing prospects firming

Admittedly, macro-economic data has been mixed. While concerns about elevated trade uncertainty has shown up in financial markets and economic sentiment indicators, other domestic demand gauges like employment, consumer spending and housing investment remain solid.

For central banks, the key concern is actual inflation, which, for most developed economies, has continued to undershoot the broadly adopted 2% inflation target. More importantly, market measures of inflation expectations have been softening, raising concerns that inflation expectations are becoming unanchored, which in turn increases the risk of creating a self-fulfilling dynamic with actual inflation. Inflation shortfalls on the back of a less favourable global growth backdrop coupled with rising downside risks, increases the need for some policy support to sustain economic momentum in the near-term.

The need to act to stave off near-term weakness has become more pressing given the compressed conventional policy space, exemplified by prevailing interest rates that are already very low by historical standards. Indeed, as Fed Chair Jerome Powell alluded to in his June policy meeting press conference, an ounce of prevention via pre-emptive easing is worth more than a pound of interest rate cuts in the face of an economic downturn.

With the Federal Reserve having given clear signals that interest rate cuts are imminent, the market’s focus has shifted to the magnitude of the cuts. Based on the Fed Funds futures pricing, the market expects the Fed to cut interest rates by as much as 100 basis points by the end of 2019. Expectations of such a drastic move might be too dovish. While the Fed may soften the expected path of policy, we do not expect it to be steeply lower. After all, they are fending off slackness in near-term growth, as opposed to fighting a full-scale recession.

Yet, not all central banks are created equal. The Federal Reserve, which is further along in their normalisation cycle, has room to cut interest rates. In this case, small interest rate cuts might yield meaningful expansionary effects. The same cannot be said for the European Central Bank and the Bank of Japan, which may have to lean on unconventional monetary policy tools in the form of quantitative easing or more negative interest rates to encourage economic growth. With policy settings already as accommodative as it is, the marginal effects of further easing are unlikely to be very substantial.

Nevertheless, the prospect of some near-term monetary easing remains a comfort to financial markets.

Taking on risk in July

On balance, the combination of a temporary trade war détente and prospects of near-term monetary easing provide a conducive environment for risk assets in the second half. As it stands, a recession in the next 12 months does not seem particularly likely. Hence, some pre-emptive easing in monetary policy could push risk assets higher still.

In this, equities will likely respond positively, and credit spreads will narrow. Safe havens like US Treasuries, gold, Japanese Yen and the Swiss Franc may take a breather on the back of a risk-on tone in the market. The Chinese yuan will likely strengthen while the US Dollar could remain sluggish as the futures market continue to price in better-than-even odds of interest rate cuts in 2019.

Overweight on equities and high yield bonds

A dovish Federal Reserve, sluggish US Dollar and a more positive trade backdrop will be supportive for Asia ex-Japan stocks. In addition, earnings of US companies continue to hold up and have not been too heavily weighed down by trade concerns. US earnings growth remains positive and stocks will likely benefit from the Federal Reserve’s more cautious stance alongside the calm in trade tensions. These reasons underscore our positive view on Asia ex-Japan and US stocks.

Meanwhile, there is a dearth of strong market catalysts in relatively cheaper European and Japanese markets. As stated earlier, further monetary easing in these economies might not be as effective on the margins given the already loose policy setting. Furthermore, the spectre of a “no-deal” Brexit still hangs over the European market and could adversely impact sentiment as the deadline approaches. The changing of guards at the ECB might be another risk to watch, as the next President might revert to a less dovish stance.

On credit, heightened prospects of near-term monetary easing, favourable top-down sovereign and bottom-up company fundamentals as well as a sluggish US Dollar, appear supportive of high yield bonds. This asset class is ripe to benefit from lower interest rates, low default rates, a reasonably sound growth environment and increased risk appetite in the wake of dovish central bank guidance and a temporary US-China trade truce. Within this asset class, Emerging Market High Yield bonds are more attractively valued versus their US counterparts and offer a higher carry in a reach-for-yield environment.

All in, we express our risk-on view through an overweight stance on equities and high yield bonds, with a preference for Asia ex-Japan and US stocks as well as Emerging Market High Yield bonds.

Don’t throw caution to the wind

However, investors should not throw caution to the wind. Again, a trade truce is not a resolution. And there are still question marks on the Trump administration’s stance on auto imports, which is a particular risk to the European Union and Japan. Recent history has shown that the White House has become increasingly unpredictable where trade policy is concerned.

As such, markets might be rocked by the occasional tariff threat and potential breakdown in negotiations. Diversification and haven assets will still have a part to play in anchoring portfolio returns amid a still volatile and uncertain market.

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