Regional views

Cash’s place in a portfolio, agricultural trade and a possible US-China deal, and more weekly insights from around the globe.


18 Mar 2019 China's shopping list might upend trade

Talk of a potential trade deal between the US and China is buzzing among the agricultural investment community. And for good reason – the lifting of the trade tariffs imposed on one another's goods last year would be a boon for traders and commodity prices.

But while this alone is cause for excitement, the bigger story is the USD 30 billion of US agricultural products that China reportedly plans to buy annually. The proposed amount would be on top of pre-trade levy levels, and would include purchases of major bulk commodities (soybeans, coarse grains, wheat, cotton and ethanol).

Details are sparse at the moment, and specifics on enforcement and logistics are absent. But if this proposal turns into reality, it would fundamentally alter global trade flows of agriculture for the foreseeable future. To understand why, some context is needed.

In 2017, before the tit-for-tat tariff exchange, China imported USD 21bn worth of agricultural products from the US. So this would mean it plans to purchase roughly USD 51bn worth of goods per year. The extra USD 30bn would go toward gobbling up the US's leftover supply of wheat, corn and soybeans, which at current prices would be USD 20.6bn in total for 2018–19 reserves. This would leave another USD 9.4bn to binge on other US products like meat, cotton, dried distiller grains, ethanol, seafood and sorghum.

Unfortunately for China's agricultural trading partners, they would effectively be shut out of certain markets if such a deal materializes. By wiping US reserves clean, Beijing would be buying more supply than it needs for goods like soybeans given that demand has likely peaked (at USD 40bn) and the government has been pushing for feed-use efficiency. This is especially bad news for producers like Brazil, which has benefited the most from the trade war and ranks China as its largest export destination.

There would also be considerable collateral damage on other producers, like Argentina and Brazil, and other big trading partners, like Australia and Canada. Trade flows to China and out of the US would ultimately need to adjust – and this would mark a major shift in the global status quo, as these two countries dominate the world's agriculture industry.

For example, if the US increases its market share of soybeans shipped to China from 34% in 2017–18 to 50% in 2019–20, or an extra 45m tons, this would displace imports from Brazil, Argentina and Canada. Meanwhile, the US's trading partners of Mexico, Japan and Indonesia would need to source oilseeds from other suppliers. Likewise, greater US exports of wheat, rice and corn to China would affect Australia and Southeast Asia, while an increase of Chinese meat protein imports from the US would hurt the overall export volumes of Australia, Brazil and New Zealand.

According to press reports, a summit between Presidents Donald Trump and Xi Jinping will likely be in April (or perhaps even in March). Still, it may take time before details emerge on enforcement and the actual shopping list. It also remains to be seen whether some of the more thorny issues, like forced technology transfers, non-tariff barriers and China's management of the USDCNY exchange rate, will be tackled to any significant extent at the next meeting.

So we're keeping a close eye on developments at the moment, rather than updating our positioning. Besides the features of a trade deal, we're also tracking US spring plantings, weather in Asia and the spread of African swine fever in China as factors that could affect agricultural prices.

Author: Wayne Gordon, Analyst


Emerging Markets

18 Mar 2019 As elections kick off, focus on what comes after

As we highlighted in the 2019 edition of our Emerging Markets Electoral Monitor, some key nations will hold potentially pivotal elections this year. In Eastern Europe and Africa, they go in full swing this month as two countries, Turkey and Ukraine, take to the polls on the same day; South Africa follows about five weeks later. Headlines ahead of each vote may trigger market jitters, but investors must focus on fundamental economic and corporate factors and what politics actually means to the investment outlook. Ultimately, election outcomes should reduce market uncertainty and enable investors to concentrate on policy measures and their implementation.

Turkey will hold local elections on 31 March. The voting for mayors and councilors will gauge the public support for the ruling AK Party of President Recep Tayyip Erdogan. Following last June's general election, the Turkish economy has battled high inflation, weak growth, and rising unemployment. In the last local balloting, in 2014, two in five voters supported the AKP. Whether it can meet or exceed this threshold will be worth watching, particularly in the larger cities.

Most market observers don't expect any major surprises. Still, headlines and potentially populist measures in the run-up to the vote could make investors edgy. Since no new elections are scheduled until 2023, policymakers have an opportunity to implement economic measures and reforms to reduce vulnerabilities, such as dependence on energy imports and a large stock of dollar debt. Although Turkey managed to stabilize markets in recent months, we think risks of renewed setbacks linger.

In Ukraine, the presidential election also on 31 March matters for diplomatic and wider geopolitical reasons. More than three dozen candidates are officially running. If no one receives an absolute majority, a second round will take place on 21 April. The poll frontrunners are Volodymyr Zelensky, known for his entertainment career; incumbent Petro Poroshenko; and former Prime Minister Yulia Tymoshenko. Given current alliances and a large number of undecided voters, the result is too difficult to predict and a second round is highly likely. The outcome will be important for Ukraine's reform agenda and its relations with the EU and Russia.

On 8 May, South Africans will elect the National Assembly, which will later decide on the country’s president. The implementation of urgently needed reforms is closely linked to voter support for the ruling African National Congress (ANC) and its reform-oriented leadership. The ANC looks likely to retain a majority, and incumbent President Cyril Ramaphosa appears set to stay in office. But the magnitude of victory will determine the support for his reform plans and his ability to unite different party factions. His standing would be harmed if the result fell significantly below the 62% the ANC achieved in the last general election.

Apart from the uncertainty in the political outlook, the focus on ANC unity may delay reforms ahead of and in the wake of the election, and populist headlines might trigger market skepticism. How the rating agencies react will be important. Moody's still assigns an investment grade rating to local government debt, and a downgrade remains a risk. A focus on how to tackle structural challenges, fight corruption, and boost job creation would support South African assets, but progress on these should guide investors on taking a more optimistic stance.

In the meantime, while Turkey's municipal election introduces some uncertainty in the political sphere, the Turkish central bank has maintained the policy rate at 24%, which should support the lira ahead of the vote. The rand, on the other hand, remains vulnerable to setbacks.

Author: Jorge O. Mariscal, Regional Chief Investment Officer Emerging Markets


18 Mar 2019 Italy: Lower risks, but lower growth

Concerns about a fiscal clash between the M5S-Lega government and the European Commission have eased and sovereign spreads have narrowed. Starting from the so-called "government contract", which implied a nearly 6% budget deficit, the government initially backtracked to 2.4%, and then finally to 2% to reach an agreement with the European Commission.

A more realistic approach by the government has been regarded positively by investors both because of the deficit reduction, although more may be needed in coming months, and because of the willingness to maintain a dialogue with the European Commission. On this basis, we think the political risk stemming from Italy has lessened since last year.

This is as much good news as we can report this time though because political turmoil has translated into a confidence shock. In fact, the anecdotal evidence is that a number of corporates have decided to push back investments until policy visibility improves. Similarly, the government is slowing infrastructure investment. The two issues combined have impacted capex and fixed capital formation.

To be clear, part of the slowdown was due to external headwinds, similar to other Euro-area countries, ranging from issues in the automotive sector, a pick-up in oil prices earlier in the year and soft external demand. Nevertheless, the Italian economy was hit harder because of the prolonged policy uncertainty and its implications for business confidence.

In addition, although the budget saga between Brussels and Rome was more or less peacefully resolved, fiscal discussion may return in the second part of the year, as weaker GDP growth will require fine-tuning of the budget and potentially more fiscal efforts in 2020. Avoiding a VAT increase next year may prove challenging in the absence of a marked macroeconomic recovery.

Indeed, business confidence remains downbeat while industrial production seems to have recovered in the first few months of the year. On the back of weaker data in H2 2018, we have lowered our GDP growth forecast to 0.4% in 2019 from 1% previously.

In the background, while political risk has declined, the picture remains complex and has changed significantly since Italy's last elections. In fact, since those elections a year ago, Lega has roughly doubled its support and now polls steadily above 30%. Over the same period, M5S's popularity has declined significantly and is now down 10ppt to c22%. The recent regional elections in Abruzzo and Sardinia painted a similar picture. As such, the balance of power within the government has shifted.

The government's stability therefore remains uncertain, frictions are a constant on matters such as immigration as well as infrastructures, and we continue to expect a cabinet reshuffle, if not fresh elections, in the course of this year. This wouldn't be this necessarily a negative market development; in fact, a center-right coalition government or a technocratic government may be regarded positively by investors.

Author: Matteo Ramenghi, Chief Investment Officer UBS WM Italy

United Kingdom

18 Mar 2019 Brexit and UK equities

I get the sense some people are perhaps feeling a bit jaded by Brexit, so I will instead start this editorial with an update on the earnings outlook for the UK. Then perhaps once I have you reading, I can then sneak in some quick comments on how Brexit might impact the UK equity market! And for those of you who really don't want to think about it but have a UK equity exposure, I then suggest following a diversified dividend strategy, which should navigate most Brexit outcomes well.

So, turning to the fundamentals, the 4Q earnings season reported by UK companies has been mixed. While overall earnings missed expectations slightly, share prices in aggregate reacted positively. This shows the greater importance investors place on outlook statements and companies' cash return statements, as well as some weak expectations coming into the earnings season.

Among the banks, generally decent domestic operations were offset by weaker revenues in investment banking and weaker-than-expected growth internationally. The energy sector was mixed on 4Q numbers, but the shares reacted positively on the better cash-flow guidance and outlook. The pharma sector did well, although generally with the help of some one-off benefits. The telecoms sectors missed expectations, but consumer overall generally held up better against weak expectations.

All in all we expect single-digit earnings growth for the MSCI UK for 2019. We see a strong oil price recovery as the main upside risk and sterling strength as the main downside risk. Our earnings expectation is predicated on the UK leaving the EU and moving into a transition period, which is our working assumption. However, the risks of other outcomes for Brexit have been rising, given the recent parliamentary votes and the impending deadline.

The UK's departure from the EU remains an uncertainty for the market, but we expect intra-market reactions will be sharper than any moves in the headline index. In particular, domestic stocks should outperform should there be a deal or no Brexit, while international stocks should outperform in case of no deal (which looks increasingly less likely) or continued political uncertainty that causes sterling weakness. That said, domestic stocks on average are trading at just a single-digit earnings discount to international stocks, versus a 20% discount at their cheapest, suggesting a hard exit is no longer in the price of the equity market.

For those who don't want to think about Brexit, a diversified dividend strategy might be the solution. It takes a spread across sectors and currency exposures to harness the attractive 5% dividend yield of the UK market, while at the same time benefiting from potential bond yield or currency volatility. We believe this is the best strategy to navigate any Brexit outcome and benefit from global growth.

Oh dear. It seems in a piece where I've tried not mention Brexit too much, I have still managed to use the word eight times! Sorry folks, but it won't be the last such piece either.

Author: Caroline Simmons, CFA, Strategist, Deputy-Head UK Investment Office

Week in review

  • The UK January GDP estimate came in higher than expected at 0.5% m/m. However, the 3m/3m rate was broadly in line with expectations at 0.2%, as weak global growth and weak investment as a result of Brexit uncertainty continue to weigh on UK growth.
  • Last week saw a string of Brexit votes, with parliament rejecting Theresa May's Withdrawal Agreement (version 2), and voting against a no deal Brexit and to extend Article 50. These are non-binding votes, but indicate parliament's point of view.

Week ahead

  • For Brexit, the focus will be on the third meaningful vote on the Brexit Withdrawal Agreement, due on Wednesday 20 March.
  • The UK labour report will be watched on 19 March to see whether there are any signs Brexit uncertainty has started to weigh on employment levels. The earnings growth numbers for January along with the inflation release for February are also due. We expect the Bank of England to stay on hold at its next MPC meeting on 21 March.

United States

18 Mar 2019 Cash ain't trash...but it sure ain't equity, either

I bristle at the dismissive attitude that some have adopted toward cash within portfolios, so the phrase "cash is trash" has always puzzled me. It conjures up images of portfolio managers discarding bundles of greenbacks along with week-old newspapers and empty Amazon boxes. I've almost been tempted to take a few "dumpster dives" into the recycling bins outside of asset management firms. Because if they truly view cash as trash, then I may need to moonlight as a trash collector.

When managed properly, cash can be a critical component within an investment portfolio.

It offers investors the flexibility to take advantage of new opportunities as they present themselves. Cash, and the ability to borrow, also provide portfolio managers with an essential Plan B to avoid liquidating assets at depressed values. Since cash is a non-correlated asset, it can also offer some respite during periods of uncertainty when conviction levels on risk assets are low. So maintaining some "frictional cash" within portfolios makes perfect sense.

But to say that cash has an appropriate place within portfolios is not to suggest that it should have a prominent one.

Most investors accept the wisdom that portfolios with heavy exposure to equities provide the best prospects for building wealth over time. For example, USD 100 invested in an all-equity portfolio in 1945 would be worth about USD 205,000 today, compared with USD 4,600 for an all-government bond portfolio or USD 1,700 for cash (T-bills). We generally advise against all-equity portfolios since diversification benefits can reduce risk and improve returns, but this helps to illustrate the importance of having a healthy allocation to stocks.

However, we also recognize that those returns are never uniform either across or within cycles.

Some expansions are stronger than others, so asset-class returns vary between economic cycles. It's also clear that there are divergences in asset class performance at different stages of each cycle. So while portfolios with large equity allocations may be ideal for the long term, they may not fare as well during shorter periods.

With the current economic expansion having now shifted to "late cycle," it is this concern that seems to be driving investors to consider increasing their cash weightings now. But as we have stressed repeatedly in our business cycle work, the late stage of the business cycle should not be confused with the terminal phase (e.g., a recession). Our work shows that equity markets continue to do well in the late stage of the cycle, consistently outperforming both bonds and cash. For example, the median six-month return for equities has been 6.6% during the late stage of the cycle, versus just 2.8% for cash.

For those who believe that things might be different this time around, it's instructive to assess how valuations across each of the major asset classes compare to historical norms. What we find is that while price-to-earnings multiples for stocks are right in line with the historical average for the late stage of the cycle, at about 16.5x, the expected returns for bonds and cash are both significantly lower than in prior cycles (bond yields are 2.7% versus an average of 5.2% in prior cycles, and cash yields are just 2.4% versus 3.4% for a comparable stage in prior cycles).

So while we have entered the late stage of the business cycle, we counsel against reflexively (and prematurely) increasing cash positions. Because while cash clearly ain't trash, it sure ain't equity, either.

Author: Michael Ryan, CFA, Chief Investment Officer Americas