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Old 10-16-2018, 11:13 AM
John Tollerman John Tollerman is offline
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Default AAUC (AA UNION CAPITAL) Storm investment strategy

Global growth and an accelerating industrial production cycle show few signs of slowing. As such, market sentiment appears to be unduly negative, and we maintain our pro-risk overweight equities position, while responding to shifting risk appetite via adjustments in both sector allocations in equities and the duration of our bond holdings. The risk/reward balance is also in favor of maintaining a positive stance on Chinese equities at this moment given the excessive pessimism and cautious positioning by investors.

Salina Bo – VP OF AAUC (AA UNION CAPITAL)

Mid-September brings a host of idiosyncratic risks across emerging markets, coupled with a creeping rise in broad risk aversion. Conversely, growth in the global economy and an accelerating industrial production cycle show few signs of slowing. As such, market sentiment appears to be unduly negative, and we maintain our pro-risk overweight equities position, while re- spending to shifting risk appetite via adjustments in both sector allocations in equities and the duration of our bond holdings.

The main looming risk remains in the US-China trade tensions, with escalation likely to persist at least in the near term. At this juncture, however, the fundamental restraints on escalation remain in place: a full blown trade war will be very costly to both sides, even if it is likely to be somewhat more painful for China. US President Donald Trump has a strong incentive to continue to push China hard in order to exact both trade concessions and electoral benefits. However, there is the risk of going overboard and spooking the domestic equity markets – which could potentially negate the political benefits that might accrue from Trump’s burnishing of his “trade warrior” image.

On China’s part, the plan seems to be a continuation of the erstwhile stance of suing for peace while maintaining some semblance of indignation via tariff retaliation. There is a risk of Beijing employing other tools of retaliation and penalizing US firms operating in China, but Beijing will also want to tread carefully and avoid spooking their own markets and giving the trade hawks in the USA ammunition for accelerating the escalate.



Ultimately, there are a number of reasons to stay the course on our overweight position in China. Chinese equities retain an inherent attractiveness as the macroeconomic data appear to be on track for a strong turnaround after supportive fiscal and monetary policy measures. Additionally, the authorities have acted to stabilize the CNY, which in turn should stem the translation losses in stocks of Chinese companies listed in Hong Kong and the USA. Earnings expectations going into 2019 continue to remain robust and add to the underlying attractiveness of Chinese equities.

On the flip side, the continued escalation is an undeniable concern. The size of the upcoming tranche of tariffs, and the pace at which it is applied, holds risks of negative surprises for the market, as does the potential for China’s response to be unexpectedly aggressive. For now, however, we scale off the sell-off points to the likelihood that a significant amount of the escalation is already priced in and the balance of risks going forward argues for holding fast and riding this out.

Of course, we are fully aware of the simmering risks in the rest of the emerging market (EM) segment, mainly in Turkey and Argentina. The Turkish Lira (TRY), already hobbled by weak underlying macroeconomic fundamentals, has been hammered by a trade and diplomatic spat with the USA. More recently, Argentina’s government has had to admit that fiscal shortfalls necessitated an emergency acceleration of the disbursement of USD 50 billion from the pre-agreed loan program with the International Monetary Fund (IMF). The Argentinean peso (ARS) has since followed the TRY into a full-blown currency crisis. The central banks of both countries have reacted quickly and hiked policy rates sharply, but both currencies remain severely pressured and look set to remain so for some time.

The EM stress has impacted Asian currencies to some extent, namely the members of the “Fragile Five” from the Taper Tantrum – India and Indonesia. Both have come under pressure and could stay relatively weak as long as the jitters remain. It is also worth noting however, that both of these economies have since moved to resolve some of the issues and are significantly less fragile now.

For now, we remain of the view that the contagion from Turkey and Argentina should ultimately be somewhat limited and Asia’s overall relatively strong external fundamentals will provide a buffer for the region – the US-China situation should prove far more consequential. Nevertheless, a perfect storm of EM risk and a trade war are still possible, and we continue to watch the financial weather reports.

Asian equities: Handcuffed by trade uncertainty Asian equity markets have come under renewed pressure, despite the healthy macro environment and policy stimulus by China, as trade uncertainty, coupled with concerns about EM contagion spilling over from periphery markets in other regions to sturdier parts of Asia, are keeping investors on the side-lines. We note that, with the low probability of a near-term resolution to the trade dispute and the material threat of additional tariffs on Chinese imports, the trade risk is likely to continue to weigh on sentiment. Nonetheless, the risk-reward balance is in favor of maintaining a positive stance on Chinese equities at this moment given the excessive pessimism and cautious positioning by investors.

The continued escalation of the trade dispute, and lingering growth concerns have led to a bear market in Chinese equities. From its peak in January, valuation has de-rated by a quarter of its market value. Turkey and Brazil are the only other markets globally that have witnessed a greater magnitude of valuation derating despite the fact that there is no parallel comparison between China and these two markets on (1) size and importance of their economies, (2) current political environment, (3) external position and policy tools, and (4) the underlying positive earnings growth outlook. This reflects our view that markets have largely priced in near-term trade uncertainties and have almost completely ruled out a reconciliation between both parties, while also discounting China’s ability to use its available policy tools to negate the economic detriment of further escalation in the trade spat.

As a consequence of the trade concerns, investors are heavily discounting the underlying earnings growth outlook on Chinese equities. As the fiscal and monetary stimuli start to kick in over the coming months, we believe economic policy will become a tailwind, supporting the market’s ability to deliver another 15% earnings growth in 2019, in addition to 16% growth in 2018, thus positioning China as one of the fastest-growing equity markets.

Given this underlying earnings growth outlook as well as policy support and an attractive valuation, we believe investors are better off maintaining their exposure to Chinese equities and riding out the near-term volatility. We think this resilience should bear fruit in the form of a rebound later in the year and we thus reiterate our outperform view on China in our Asia equity strategy. Elsewhere, we remain positive on Singapore equities given healthy earnings, a high dividend yield, and an attractive valuation. Conversely, we remain negative on India despite its stark outperformance recently, as the market is richly valued. The earnings downgrade cycle is still going and could accelerate if the recent currency depreciation begins to impact domestic consumption. Upcoming state elections in Q4 could also lead to heightened political risk and a pullback in the market.

However, to reduce our exposure to the risk of a full-fledged trade war, we no longer have a negative view on Malaysia. Although Malaysia suffers from low growth and an unattractive valuation, the defensive nature of the market and large holdings by domestic financial institutions make it less susceptible to foreign outflows. As such, if emerging markets come under further pressure, a larger allocation to Malaysia should help cushion the impact for investors.

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