OCBC OneWealth App– Resilient but US-China trade risks remain

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Resilient but US-China trade risks remain

26 November 2018

Prospects may not be 2017-fabulous, but still sound nonetheless

Emerging Markets continue to be buffeted by a series of challenges, including higher US interest rates, escalating US-China trade tensions, a strengthening greenback and other geo-political risks. Taking into account these economic headwinds, the IMF has turned less optimistic, revising down its growth projections for a broad set of economies.

In particular, the IMF shaved off growth forecasts for emerging markets by 0.2% in 2018 and 0.4% in 2019. Yet, we observe some resilience in Asia, where growth forecasts have been revised by less than other emerging markets.

Projections for 2018 growth was maintained at 5.3% while forecasts for 2019 was decreased by 0.2%, less than the 0.4% revision for Emerging Markets more broadly.

This sustained strength of Asia – in terms of the overall growth rate and the small scale of downward revision – stands out, especially amid current concerns over US-China trade tensions. As can be gleaned from Chart 1, major ASEAN economies have been clocking around a 5% growth rate, the average since 1990, despite escalating external pressures.

Shifting production facilities

US-China trade tensions take top billing among these external pressures. Indeed, concerns over tariffs and worries about a protracted trade conflict have led firms to adjust their supply chain links to skirt these taxes. A clear beneficiary of these business considerations is Southeast Asia.

A recent survey jointly conducted by the American Chamber of Commerce in China and Shanghai showed that 35.4% of the over 430 firms surveyed have relocated or are considering relocating their China-based manufacturing facilities to other countries due to concerns about the possible long-term persistence of US-China trade tensions.

Of this subset of firms, more than half are looking to position manufacturing plants in Southeast Asia, effectively shifting their supply chain away from the target of the US’ trade-related ire.

Won't take things sitting down

Not one to take things sitting down, the Chinese government has displayed a strong commitment to soften the blow from US trade tariffs, having put into action a long list of policies that run the gamut of income tax cuts, looser credit and increases in infrastructure spending. As it stands, China’s Purchasing Manager Indices (PMIs) remain above the 50-point expansionary threshold, indicating that the impact of US’ protectionist actions has not been too severe – for now. After all, exports account for about one-fifth of China’s GDP and only one-fifth of those are sent to the US. The steady increase in domestic consumption as a proportion of GDP also improves China’s resilience to the US’ trade pressures.

That said, while 10% tariffs on US$250 billion worth of Chinese exports might not inflict too much pain in the near term, a jump to a 25% tax may well do the trick (the step-up in tariff rates is tentatively planned for January 2019). Depending on how negotiations between the US and China pan out in the interim, this might become a huge concern for markets in 2019.

Not 1997 anymore

Beyond trade, observers may point to the weakness in Argentina and Turkey as a harbinger of worse things to come for Emerging Market economies. But nuance matters. Problems faced by these economies are idiosyncratic or country-specific. More importantly, they are not systemic concerns.

By and large, major Asian economies are running external surpluses as the memories of the Asian Financial Crisis two decades ago continue to inform policy-making. Cautious fiscal policies and control over inflation also give Asia plenty of policy ammunition if needed.

Countries like India and Indonesia may come under pressure due to an external deficit approaching 3% of GDP – typically a danger level – but steady reform and solid domestic fundamentals should make their growth more resilient.

Stocks look attractively valued

Despite Asia’s resilience to the challenging global environment, the region has received little love from investors. Markets appear to have painted Asia with a fairly broad brush, taking every opportunity to punish the region for any perceived deterioration in US-China trade relations.

The US, which has enjoyed an unusual late-cycle acceleration in large part due to President Trump’s fiscal boost, seemed to be the safer bet amid the trade kerfuffle. The domestic consumption-driven behemoth appeared somewhat insulated from the lashings of two-way protectionism. Even then, the US-bet has not paid off in any substantial way this year, having turned more awry in recent months.

Many reasons have been proffered to explain the chaos on Wall Street in October and November. All seem plausible; none particularly compelling. While we won’t commit the limited space here to speculate its causes, we would point out that the recent sell-off has restored a lot of value to Asian equity markets, with the MSCI Asia ex-Japan index trading at a large discount to its developed market peers. As it stands, the MSCI Asia ex-Japan index is trading at a blended forward Price-to-Earnings of 11.2x (as at 16 Nov), about one standard deviation below the 5-year average and 0.6 standard deviation below the 10-year average.

Meanwhile, the earnings backdrop in Asia remains encouraging as well, with earnings growth projected to grow at about 10% in 2019.

Indeed, despite Asia’s poor performance this year, we continue to believe that Asian equities offer a level of opportunity that justifies the risk for investors with a longer-term horizon. As such, we remain positive on the region.

Deal or no deal: All eyes on the Trump-Xi rendezvous on 30 November – 1 December

Nevertheless, we are not blind to the risks facing Asia in the near term. Indeed, near-term prospects for Asian equity markets largely hinges on the outcome of the forthcoming US-China trade negotiations at the side-lines of the G-20 meeting in late November. Should President Trump and President Xi manage to cobble together a Kim or Juncker-type agreement - broad-based; few bullet points; no real details - come the G-20 meeting, equity markets may cheer the news of a trade war armistice and rally strongly.

Given the complex nature of the US-China dispute, we shouldn’t expect any comprehensive deal to complement any sort of agreement. A broad framework outlining the future path of negotiations would be the likely result in such an outcome.

However, any broad disagreement would result in the escalation of US-China political tensions which may portend a protracted battle between these colossal rivals. We expect to observe heightened market turbulence and broad risk-off pressure should this scenario play out. As it is, the “sell first, ask questions later” mantra that the markets’ seem to live by in recent months has been particularly unsettling for investors. Any of these outcomes is probable. The politics itself is unpredictable.

Major disruptions in global trade and worse-than-expected slowdown in the Chinese economy would pose great risks to the entire region. Even so, investors should not take their eyes off the long-term prize. The ensuing turbulence that may erupt should there be a standoff between the US and China might open up interesting opportunities for market entry for investors with a long-term horizon. We remain watchful and vigilant in this space.

Stay active to manage the risks

Indeed, recognising these risks does not mean becoming needlessly paralysed by them. Rather, investors should carefully consider the type of investment strategy to implement so as to take prudent exposure to the region - a strategy that is able to capture the long-term upside, whilst also navigate the short-term turbulence.

In view of wider return dispersions and potential macro and idiosyncratic risks ahead, an investor may not be rewarded through passive management alone.

A potentially choppy investment terrain ahead requires a deft investment hand at the helm to rebalance the portfolio when necessary or take exposure to certain assets as and when opportunities arise.

As Chart 7 shows, actively managed equity or multi-asset strategies were able to ride through the turbulence this year better than a benchmark-tracking strategy.

Ultimately, active managers can leverage the efforts of fundamental analysts on the ground, who can enhance discoverability of investible information and provide a more nuanced and deeper understanding of actual domestic conditions. This in turn provides some competitive advantage that can result in long-term outperformance versus passive strategies, especially in markets that are less transparent.

A unit trust solution can meet the needs of bottom-up security selection, asset diversification as well as active management. This can offer investors some peace of mind when investing the long-term potential of this region amidst an admittedly turbulent time.

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