Since Fed Chair Powell’s testimony on 10 July, performances across the cross-asset landscape have been mixed. Equities and high-yield bond spreads have lost ground, treasury yields treaded water, while safe havens gold and the yen gained.
Global growth is a key driver of performance for equities and high-yield bonds, and the latest price weakness in these asset classes was partially caused by concern over recent Chinese data that showed growth slowing from 6.4% in 1Q to 6.2% in 2Q.
China’s economic momentum in 2Q eased due to the re-escalation of trade tensions in May, but the deceleration does not appear dire. Although we tend not to read too much into monthly fluctuations, it is notable that the latest Chinese June data is flagging some stabilization on a month-on-month basis: industrial production growth rose to 6.3% in June (versus 5.0% in May), and retail sales rose to 9.8% in June (versus 5.6% in May).
Even as Sino-US trade risks persist into H2 2019, we believe Chinese policy makers have sufficient tools to engineer a soft economic landing. In addition to stepping up fiscal easing to stimulate infrastructure investment and consumption, the Chinese would likely engage monetary easing after the Fed cuts rates.
In terms of global growth, one phenomenon that has stood out over the last 12 months is the divergence between weakening soft data (business surveys such as manufacturing PMIs) and relatively resilient hard data (including industrial production, retail sales, unemployment rate).
Ths reflects the negative Sino-US trade shock on manufacturing sentiment which has not passed. Although much will hinge on the progress of Sino-US trade negotiations, we see good odds of a partial trade deal before the 2020 US elections, and good odds that the global easing cycle led by the Fed will eventually help stabilize the weak manufacturing sector ahead.
As we move through the rest of July, investors will grapple with uncertainties related to two major central bank meetings (ECB on 25 July; Fed on 31 July) and the Q2 2019 earnings season which will shed light over the outlook for corporate profitability.
While it is too early to draw conclusions on the earnings season, it is proceeding smoothly so far. To date, 16% of the S&P 500 companies have released results, and 61% have beat sales estimates while 78% beat earnings estimates.
Aggregate expectations for the S&P500 do not appear overly aggressive to us at this juncture. The market is expecting a 2% yoy decline in 2Q EPS, and 2019E full year EPS expectations of $166 (up 2% yoy) seem achievable.
What is more important than 2Q earnings, however, is forward guidance on corporate profitability. The current consensus reflects a temporary dip in earnings growth before a recovery in H2 2019 and 2020, and investors will carefully parse management language for potential disappointment, which might inject some near-term volatility into equities and high-yield bond markets following the sharp run-up over the year to date.
Later this week, we expect the ECB to signal an easing bias as it seeks to pave the way for potential rate cut and a new quantitative easing (QE) program in Sep 2019.
At the end of July, we expect the Fed to cut rates by 25 bps. A 50bp cut is less likely but cannot be ruled out. Another 25 bp cut will likely follow in September. Historically, insurance rate cuts by the Fed have been around 75 bps in total, so we could expect another in December or later, although the timing and magnitude will depend on further developments in trade and the economy.
We expect rate cuts from other central banks in the next few months following the Fed, and note that some emerging market (EM) central banks, such as the Bank of Korea, Bank Indonesia and the South African Reserve bank, has already moved ahead of the G3.
With our baseline scenario of synchronized global easing and a limited likelihood of a recession over 12 months, we see grounds to be overweight risk in our asset allocation strategy.
In fixed income, we are overweight high-yield (HY) bonds, particularly emerging markets (EM) HY and Chinese developers, which will benefit from lower rates, a relatively more supportive environment for growth, and also provide sought-after carry in a reach-for-yield environment.
We are also overweight on equities in the US and Asia ex. Japan. In China, we prefer sectors related to domestic consumption, infrastructure and construction, which should benefit as fiscal stimulus further accelerates.Disclaimer applicable to recommendation
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