Waiting for clarity

written by Min Lan Tan, Head Chief Investment Office APAC, UBS Global Wealth Management

China and the US are locked in a high-stakes test of resolve. Neither side wants to give way. But if one side pushes past the other’s breaking point, tensions could rise dramatically and for an extended period. It looked like the US might have crossed that threshold by banning technology sales to Huawei. 

However, at the recent G20 meeting in Osaka, Japan, US President Donald Trump and China’s President Xi Jinping succeeded in averting a breakdown of talks, even while failing to produce a breakthrough to reduce tariffs. The most likely outcome – as of now - appears to be a prolonged truce on trade, with neither an escalation nor a removal of tariffs. 

Given such elevated uncertainty, we have cut portfolio risk in recent weeks and await further clarity to emerge on how US-China relations pan out. Still, while the downside risks are clear, dovish central banks open up opportunities to take advantage of interest rate carry and yield.

Fed cuts would be a cushion

The Federal Reserve has held interest rates on hold this year, but in June it signaled a strong bias to lower rates in the near future. Our base case now calls for a 50bps cut in July, but any further evidence of deterioration in the labor market could prompt more cuts. Given that the market is pricing in roughly three rate cuts by the end of the year, anything less would disappoint expectations and result in some volatility in rates. 

Global monetary easing will likely help the region’s economy, but how Asian markets react to a Fed rate cut will depend on the context. If the Fed cuts to stabilize the economy following a major trade escalation, the impact would likely be marginal as investors focus on the economic and earnings fallout in Asia. But if the Fed makes insurance cuts amid a trade truce, the extra support could be a boon for Asian markets as business confidence strengthens and investors buy cheaply valued Asian assets.

Trade war starting to bite

The trade and the global IT sector slowdowns are weighing heavily on industrial production in the region. China data has been mixed. On the upside, retail sales posted a strong 2.1% m/m gain in May after a prolonged period of weakness, likely benefiting from recent tax reductions. Steel production and housing also remained robust. On the downside, fixed-asset investment decelerated to its softest pace since mid-2018. China’s exports to the US rose in May, but this was likely due to front-loading ahead of higher tariffs in June and could dip again in the coming months as recent tariff hikes take effect. 

Meanwhile, new policy measures to release more funds for infrastructure to offset trade-war-related headwinds continue. China’s finance ministry announced it will relax the use of proceeds from a special local government bond issuance, allowing some to be used as equity capital for major infrastructure projects. Plus regulators have requested that the annual local government bond quota be fulfilled by 3Q. We also expect another 100–200bps of broad-based cuts to the reserve requirement ratio in 2H. Outside China, we anticipate further interest rate cuts across Asia, including in the Philippines (75bps) and Indonesia (50bps).

TAA: Taking up an option

We remain overweight China versus Hong Kong and Malaysia versus Thailand, and long SGDTHB and long IDRPHP. In our global tactical asset allocation, we are overweight global equities hedged with a put option on the S&P 500, long US and Japanese equities (versus Eurozone stocks), short the AUD versus the USD and the GBP, and overweight a basket of high-yielding emerging market currencies (INR, IDR, and ZAR) versus a basket of lower yielding currencies (AUD, NZD and TWD). 

Given the uncertainty in US-China relations despite the current truce on trade, we hold an out-of-the-money call option on the Taiwan stock market (i.e. the TAIEX). We choose Taiwan because it is highly sensitive to trade tensions and valuations reflect considerable bad news, so it could benefit from the potential upside risk of a trade truce.

Asset class views

Equities: Asia ex-Japan (AxJ) equities are up close to 12% year-to-date, and the benchmark’s price-to-book valuation is attractive at 1.50x. But uncertainties cloud the region’s earnings outlook. If the US implements a 25% tariff on all Chinese goods, we estimate earnings growth would fall from 6.5% currently to 2% to 1% this year and next year. So we remain neutral on AxJ equities in our Asia TAA and remain selective in our bottom-up picks. 

We like high cash-flow-generative names that can reinvest for faster growth, or can return cash through higher payouts and dividends. Specifically, we like: (1) financials in Singapore, China and Hong Kong for yield; (2) Chinese internet and Korean technology leaders for solid share buyback prospects; (3) telecom operators in Korea, Malaysia and Indonesia; and (4) petrochemicals in Taiwan. High-dividend-yielding stocks have outperformed the MSCI Asia ex-Japan Index by 6ppt and are more defensive, achieving 35% less drawdown over the past one year. 

In China, we like stocks than can benefit from ongoing policy support – i.e. banks, materials, real estate and consumer staples. 

Credit: Credit spreads have widened modestly in Asia since April, by 7bps in investment grade (IG) and by 40bps in high yield (HY). Lower US rates have helped offset the negative drag from a rise in trade tensions, leaving the overall yield-to-maturity for HY at 7.3% (down 15bps) and for IG at 3.8% (down 45bps). We think returns will be limited to carry in 2H19, and given the strong performance year to-date, investors should look to trade up in quality. We expect our total return for 2H19 to be 2–3% for HY and  0–1% for IG. 

FX: APAC currencies have gained around 1% (on average) versus the US dollar in the past month, largely driven by expectations of Fed rate cuts. Against a backdrop of dovish global central banks, the JPY would be a clear winner in the region. A prolonged ceasefire in the ongoing US-China trade war should keep  USDCNY trading in a 6.7–7.1 range.