The risk-off move in the cross-asset landscape over the last week was sparked by a weak US manufacturing PMI report which drove concerns over the economic outlook.
The US ISM manufacturing PMI for September came in at a weak 47.8 – near the lows for this cycle – badly missing expectations at a time when investors were looking for signs of stabilization in global manufacturing after two Fed rate cuts in July and September.
Latest data also show that the manufacturing slump is starting to spill over to the still-healthy and much larger services sector, although a respectable 136k jobs created in September suggest some degree of resiliency in the economy.
Overall, this points to a higher degree of uncertainty for the economic outlook than previously thought, and that the worst of the slowdown is likely ahead – and not behind us – as trade-related pressures continue to weigh on business sentiment.
We see some signs of stress in the lower quality tiers of US credit with year-to-date excess returns in the CCC rating tier recently turning negative. This phenomenon is unusual in a year of double-digit returns for US high-yield and has been, to a large extent, driven by challenging conditions in the energy sector, with some notable defaults such as Weatherford International.
Considering that manufacturing and fixed investment growth are going through a sustained struggle and that the outlook for oil demand remains muted, we see the trend in US credit leaning towards quality spread widening.
Against an uncertain economic backdrop, we see the Fed making one to two more 25bp cuts over the next six months.
We judge an October Fed cut of 25bp to be a live decision, and the outcome will depend on the Fed’s take on the economy and the result of the high-level US-China trade talks taking place this week.
A comprehensive US-China trade deal is unlikely in our view, and this is in line with recent reports that China is looking to narrow the scope of discussions and will not address some US demands such as industrial policy reform.
However, a limited and temporary agreement in 4Q 2019 – often referred to as a “mini-deal” in the media – shouldn’t be ruled out and could comprise a step-based process of Chinese agricultural and energy purchases, intellectual property protection, and partial tariffs suspension or rollbacks.
This is especially as the drag from tariffs on the US economy becomes clearer to the White House, giving it greater incentive to suspend the planned tariffs in October and December, which are expected to exert significant incremental economic harm.
A mini-deal could lift markets over the near term but would not eliminate the fundamental conflicts between the two super-powers in key issues such as trade, technology and geopolitics.
One clear sign of this is recent talk of the White House potentially restricting US investments in China, which could result in wide-ranging repercussions, including delisting Chinese ADRs from US exchanges, limiting US government-linked pension funds’ investments in Chinese equities, and imposing limits on Chinese inclusion in US-run stock indices.
Against this uncertain backdrop, our asset allocation strategy reflects a slight underweight position in terms of overall risk exposure. We have a preference for investment strategies providing fixed income carry at this juncture. In equities, we remain underweight in Asia ex. Japan equities, which stands at the forefront of the trade war, and prefer exposure to names with attractive dividends backed by visible cashflow profiles.Disclaimer applicable to recommendation
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