Regional views

UK company profits, findings of the UBS Investor Sentiment survey, and more weekly insights from around the globe.


13 May 2019 Tariff escalation: Equity impact and strategy

The US and China are back at it, and uncertainty has raced to the forefront as investors rejig their risk calculations. After months of positive headlines and optimistic remarks by officials, the prospects of a US-China trade accord have gone from being a "done deal" to "still hopeful" in the span of a few tweets. But while the increased threat of new US tariffs and likely Chinese retaliation certainly complicate matters, we still see upside for Asia's equity markets this year – so long as both sides eventually agree to a deal.

In the wake of the recent escalation, Asian stock markets have surrendered a part of their previous rally. With investors pricing in a more caution outlook, the MSCI Asia ex-Japan (AxJ) benchmark has slipped further below its longer-term price-to-book valuation average of 1.6x (currently 1.46x). This leaves mid-to-high single-digit upside potential if our base case of a trade deal – a partial rollback of existing tariffs – materializes, which we expect to happen later this year.

According to our calculations, a permanent 25% US tariff on USD 200bn of Chinese exports could reduce Asia's earnings base by a low-single-digit percentage. If the US levies all Chinese exports, this percentage would rise to high single to low double digits. In the risk case that all Chinese goods are taxed and the markets fear an extended period of implementation, valuations would likely contract temporarily. That said, such a correction would likely be temporary, as investors tend to welcome the ensuing monetary and fiscal stimulus measures China's authorities usually respond with.

Indeed, if US tariffs were to weigh on activity – Chinese GDP growth this year might slip to 6% (from an expected 6.2%) as a result – the People's Bank of China could extend or amplify its easy monetary policy and offer a more generous fiscal policy; we see another 50–150bps of cuts to the reserve requirement ratio in the pipeline. Other support options could include further moves to offer credit to SMEs or to lift infrastructure spending, which should help boost investment and help cushion 2H19 economic activity. Many other Asian central banks will likely follow China's lead and ease monetary policy.

Beijing's retaliation is a wild card. The government has already announced it would retaliate; thus, it might soon issue a list of measures. This would, however, not necessarily lead to further escalation if, as previously done, the measures taken remain guarded. And we expect negotiations to continue, regardless of the recent escalation. Still, investors should not assume that ongoing negotiations will be free of tensions – in fact, the strain could even continue after a general agreement on trade is found.

For China's equity markets, the tariff hike will likely heighten volatility over the near term. But we expect Beijing to roll out more fiscal easing and monetary measures to offset the potential adverse impact on China's economy. Hence, we favor the real estate, materials, consumer staples and infrastructure sectors as they are likely to benefit from further government easing.

Author: Hartmut Issel, Analyst

Emerging Markets

14 May 2019 Election rebuke highlights need for reform

South Africans have voted to keep the ruling African National Congress as the dominant power in parliament, maintaining the absolute majority it has held since the end of apartheid. But last week's election left a clearly ominous message for the party that has been beset by infighting and corruption scandals in recent years. For the first time since 1994, the ANC received less than 60% of the vote, in a general election where the voter turnout was noticeably less than the last one. Nonetheless, the election extends the term of President Cyril Ramaphosa and gives him a chance to solve the country's economic woes.

The market's relatively muted reaction to the election result indicates that it was largely in line with expectations. During the vote count, the rand traded between 14.30 and 14.50 per US dollar; the 10-year local-currency government bond yield moved slightly lower; and the USD-denominated sovereign bonds performed broadly in line with emerging market peers. The local stock market fell hard, but much of it was due to global risk-aversion following the escalation of the US-China trade dispute.

Investors in South Africa appear to be in a wait-and-see mode until they have more visibility on what's next. Years of poor leadership and political scandals have left the economy below its growth potential, unemployment chronically high, and business and consumer confidence anemic. Moreover, government finances have weakened and are further threatened by the contingent liabilities of poorly run state-owned enterprises. To bring the country on a sustainable growth path, Ramaphosa and his team need to implement structural reforms, which will not be easy given the rifts in the party.

In the short term, the new ANC government will likely focus on quick-win actions and policies, such as the appointment of market-friendly cabinet members and new anti-corruption measures. In the long term, however, the country needs deeper reforms in vast areas of the economy, including state-owned enterprises, the labor market, healthcare, and education. It also needs to strengthen its fiscal position and stabilize the government debt burden. The IMF estimates that South Africa's public debt could reach 65% of GDP by 2023, from about 56% now. The main challenge for the government will be simultaneously achieving its social, economic, and fiscal policy objectives, which are not easily reconcilable due to the high income inequality and social tensions in the country.

Still, we think government officials are fully aware that the country is in dire need of reforms, and Ramaphosa has enough backing to continue his drive to enact them. We think the election outcome is strong enough for him to consolidate his position and attempt to keep the party in line. Compared with the period of transition from former President Jacob Zuma to Ramaphosa in early 2018, the current level of excitement is considerably lower, but this leaves room for positive surprises especially in the coming months. In the medium to longer term, some setbacks are likely, but we think it's the direction that matters and how credible policymakers' efforts are perceived.

We therefore maintain our views on South African assets despite the ANC's weaker mandate in the general election. In our view, the rand could continue to rally, and so we are keeping our three- and six-month USDZAR forecasts at 13.50, and maintaining our recommendation to buy the rand and sell the US dollar. Progress in reforms could drive a cyclical recovery in the economy, which would be credit positive, and so we reaffirm the stable credit outlook we assign to the South African sovereign. Still, we keep a neutral stance on South African bonds as we think they are fairly priced given current circumstances.

Author: Alejo Czerwonko, Emerging Markets Strategist Americas

United Kingdom

13 May 2019 How are UK company profits evolving?

Despite the recent sell off following the escalation in the Sino-US trade dispute, global equities are still up double digits year to date with the UK market up around 9%. All eyes are on the direction of global growth from here. Equity markets rebounded from an overdone sell off in 4Q 2018, but to see continued progress from here, we will need evidence of the global growth backdrop stabilizing and even improving. Earnings reported by companies are one way to look at evidence of what's going on in the wider economy.

The UK equity market has only a small number of companies that report on a quarterly basis and so we must always take the results with a pinch of salt.

However, so far, of the companies that have reported first quarter earnings, the results have, on average, beaten consensus expectations by about 4%. Companies, however, have a degree of control over their earnings, through costs, and therefore to get a fuller picture of the economy it is best to look at sales growth. And here, sales slightly missed market expectations, declining 2% y/y. Earnings, however, grew 3% y/y for the first quarter. While this provides little comfort for the overall health of global growth, it does at least tell us that UK companies are, on average, seeing little margin pressure, which is reassuring from an equity market investment perspective.

At a sector level energy, healthcare, consumer services and financials all beat earnings expectations. Energy was boosted by a recovery in the price of oil and strong cash generation; healthcare beat, but the beat was of low quality, due to one-off items. Consumer services beat as UK real wages and retail sales remain stronger than expected. Financials meanwhile had generally better capital positions and better provisions, but mixed outturns on revenues and costs.

As earnings season continues, where does it leave us on the bigger picture? Consensus estimates 3% eps growth for 2019. We think there is a small upside risk from a global growth recovery and oil moving to 75USd/bl. However, currency could pose a downside risk if sterling strengthens. It's not a very exciting earnings outlook, but the UK market is priced for it. The MSCI UK trades on a 2019 P/E of 11.4x and a 12 months forward P/E of 12.4x (vs. a long run average of 14x).

Our preferred strategy within the UK is diversified dividends, taking a spread of dividend yield and dividend growth across a mix of cyclical and defensive sectors. This should allow us to navigate bond yield volatility. Meanwhile, taking a currency-aware position should help us navigate the outcome of Brexit, should one become clear.

The week ahead
This week brings the UK labour market report, which contains details of the latest unemployment rate and average weekly earnings. It will be published on 14th May.

The week in review
Last week saw BRC retail sales for April grow faster than consensus expected at 3.7% y/y, and the Halifax house price index grew 5% y/y. Decent numbers also for the preliminary 1Q GDP print, which showed 0.5% growth q/q and 1.8% growth y/y, a pick up on the weaker 4Q growth.

Author: Caroline Simmons, CFA, Strategist

United States

13 May 2019 Mixed messages

The findings of the UBS Investor Sentiment survey certainly served to validate our own views about the current economic outlook. According to the high net worth investors and business owners surveyed, confidence in the current economic expansion remains solid. About two-thirds of businesses and 56% of high net worth investors were confident about growth prospects over the next 12 months. This relatively upbeat assessment is well supported by both hiring and investing plans, with 26% of business owners planning to hire additional workers (versus 7% reducing headcount) and 22% planning to invest more in their businesses (against 11% looking to cut spending).

This augers well for the expansion continuing.

I was also encouraged by the Investor Sentiment survey results with regard to the market outlook. According to the survey, 60% of investors have a positive outlook for the stock market over the next six months and 79% felt confident about their current financial situation. More than a quarter of those surveyed expressed a desire to increase their investments, with 67% expressing optimism on their portfolios.

Not surprisingly, what concerned investors and business owners most was the decision making of elected officials. According to the survey, the domestic political environment, national debt, cyber security, trade relations, health care costs and taxes rank as the most worrisome issues for investors. While business owners likewise cite cyber security and taxes as potential threats, they also identified rising costs from tariffs and increased regulatory burdens as risks to their business.

What might have been expected to surprise me but didn't, was both the high overall cash balances and strong preference for domestic markets. According to the survey, investors are currently maintaining cash balances in a range of 20-30% of their overall portfolios. While this is high by historical standards, it is pretty much in line with what we have experienced throughout this bull market run. Likewise, US investors prefer domestic markets by a ratio of about three-to-one over global markets. This "home bias" is a reflection of the relatively strong US equity market performance over the past decade.

What did surprise me were the conflicting views about what the recent bouts of volatility represent — as well as the level of optimism expressed by emerging market investors. While 65% of US investors view volatility as an opportunity, 79% of US investors said that they feel cautious about a potential decline in the market. This level of "conflict" among investors may well explain why cash balances remain high. Despite the challenges within many developing countries, emerging market investors were still the most optimistic. For example, 76% of investors within Latin America expressed optimism about the investment outlook within their own markets over the next six months.

Finally, there was broad agreement that a continued escalation of the trade conflict represents a threat to both financial markets and the real economy. Of the high net worth investors surveyed, 71% viewed a trade war as negative for the US equity market and 68% saw it as detrimental to the US economy. Business owners were only somewhat less downbeat, with 59% saying it was bad for stocks and 55% viewing as a drag on growth.

Leaders in both Washington and Beijing might wish to take heed…

Author: Michael Ryan, CFA, Chief Investment Officer Americas