Navigating turbulence

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

2018 has been a rough year for Asia: in US dollar terms, Asian equities are down 14.0% while Asian credits have fallen 0.8% as of 31 December. Escalating US-China trade tensions, deleveraging in China and the desynchronization of global growth which boosted the US dollar are largely to blame.

And as later-cycle dynamics take hold, slower economic growth and rising political risks will further test regional policymakers and businesses alike in the year ahead. Still, we see opportunities and believe the environment remains navigable through selectivity, diversification, and a clear long-term investment plan.

On balance, a tactical overweight position in global equities, combined with relative value trades and portfolio hedges, should provide an optimal overlay to an investor’s longer-term strategic asset allocation.

Turning points in growth and interest rates

A liquidity withdrawal is now underway in developed markets. The Federal Reserve is set to lift the fed funds rate by another 2 times to a target rate of 2.9% to 3.0% by end-2019. The European Central Bank is poised to follow suit, and end quantitative easing before 2019 starts. Meanwhile, Japan is preparing for the beginning of the end of Abenomics, likely allowing for some increase in the 10-year government bond yield as inflation steadily rises.

Meanwhile, economic growth is slowing in Asia – we forecast 5.8% GDP growth in 2019 versus 6.2% in 2018 – but typical indicators about consumption, investment and employment are not warning of recession. That said, strategic concerns like a potential reconfiguration of global supply chains are clouding the region’s investment outlook.

Without question, a key risk to watch for 2019 is whether central banks like the Fed will over-tighten in the face of decelerating economies. So far, inflation remains low enough for tightening to proceed gradually - our base case is for US core PCE to stabilize just above the Fed’s target of 2% next year. And as US growth moderates, the Fed could move to a more dovish tilt around mid-2019. The USD strength could then fade, providing relief to Asian currencies including the Singapore dollar and lifting sentiment on risk assets. Conversely, if the Fed doesn’t signal policy flexibility even as growth slows, global markets would grow increasingly sensitive to downside economic or corporate surprises.

For Asia, the silver lining is that these risks and relatively benign inflation should keep regional central banks mostly on hold, and fiscal policies supportive, especially in China.

China-US tensions – contest to continue

China-US relations, the elephant in the room, will shape Asia’s fortunes in 2019 and beyond. The 90-day trade truce between the US and China is not an all-clear, but still a significant ceasefire.

We fully expect China-US relations to get more complex and challenging in the years ahead, as the rivalry extends beyond trade and investment to differences over rules of the game, values and governance models. Importantly, neither country is likely to back off from the contest over geopolitical influence and technological supremacy. Over time, global supply chains are likely to splinter driven by security concerns, and the two economies could increasingly decouple. That said, a long cycle of fightand-talk across a broad range of economic and security issues is a more plausible outcome than a full-on conflict, given the deep economic interdependencies of the two superpowers.

For individual firms, the overall impact of supply chain reconfigurations away from China is important, but hard to quantify. Firms caught in the middle of the trade dispute face two options: stay and pay, or move. What is clear though is that corporate margins in Asia will fall – we estimate by 25–30bps in 2019 – and capex spending will eventually rise as firms are forced to diversify production bases to avoid tariffs or to ensure the security of inputs. An accelerated migration of manufacturing from China to Southeast Asia would be a windfall for the recipient countries, particularly Vietnam, which is enjoying structural consumption growth. The re-routing of Chinese M&A capital away from the US could also be a boon for start-ups and the budding new economy in the region. Yet on the upside, it is conceivable that China may now have an impetus to accelerate internal reforms for long term growth.

Strategies for a maturing investment cycle

The 2019 investment backdrop is challenging, but with selectivity, 38 diversification and tail risk management, investors can still prosper. In equities, as earnings growth eases – we estimate from 11% in 2018 to 7% in 2019 for Asia ex-Japan – investors should focus on oversold financials and technology leaders, China stimulus beneficiaries, and companies with sustainable cash flows and dividend payments.

We are tactically overweight in Asian and global equities given favorable valuations, though this view is contingent on trade tensions not escalating further. To manage this risk, we combine these positions with relative value trades (such as JPYTWD globally, and long USDKRW regionally) and portfolio hedges.

As for Asian credit, valuations and yields are compelling but volatility will likely stay elevated. We think Asian high yield (HY) bonds, which we prefer over their investment grade (IG) peers, are still worth the risk - we like stronger, short-dated (1–3 years) BB rated issuers. Within IG, we like select BBB rated government-related issues in China and Tier 2 financials in Asia. Overall, we expect Asian credit to generate total returns of about 3–4% in 2019.

For longer-term holdings, we see attractive opportunities in China’s new economy. Leading players in innovative industries – like fintech, e-commerce, gaming, and biotech – are still set to outgrow the region in the years ahead as they gain market share through disruption. The regulatory backlash in 2018 is unlikely to derail long-term growth prospects as the regulators’ intent, in our view, is to de-risk and promote more sustainable growth, and not to deter online business models or innovations. While near-term risks remain, opportunities also abound now.


UBS economic forecasts