Snapshot

Risk appetite ramped up throughout the month on increasing anticipation of a meeting between Presidents Trump and Xi at the G20 Summit in Osaka aimed at getting trade negotiations back on track. This ultimately came to fruition on the last weekend of the month, giving a last boost to the rally, which then paused to suggest that the news may be fully priced in.

For market participants, the on-again off-again trade war has been gripping and exhausting. Unsurprisingly, markets are likely to wait for evidence of firm progress before pricing in greater certainty, given the recent memory of the shock on 5 May when Trump’s tweet signalling his intent to escalate tariffs revived the trade war.

Our base case is that a trade deal still gets done. While it appeared there might be insurmountable points of disagreement, the extent of negotiations and the number of areas on which there is agreement suggest there will be a deal, especially as both leaders want and need it. During the pause in negotiations, China stepped up reform efforts that serve to better position concessions it may be prepared to make.

The changing contours of the trade war in Washington DC pose a rising risk. In Trump’s customary ‘art of the deal’ fashion, piling on demands knowing that some will be dropped is a key strategy for getting a deal done. However, his flexibility to drop demands may be diminishing given the increasingly loud bi-partisan cries for staying tough on China.

Trump eased restrictions on US companies selling hardware to Huawei to help restart negotiations, but since the ban was positioned as a national security rather than a trade-related issue, members of Congress are seeking to restrict Trump’s capacity to relax such restrictions. If Trump loses this ability to ease certain restrictions, it could turn into a deal-breaker for China.

Another important factor to watch is the extent of the economic fallout inflicted during the nearly two months of uncertainty that started with Trump’s tweet on 5 May. The bond market is suggesting that the damage is considerable and perhaps enough to tip the economy into recession; meanwhile equities are simply bullish at the prospect of more promised easing ahead.

The data is weak, but as the US is prepared to cut rates and China fine-tunes stimulus to achieve better growth, monetary and fiscal stimulus look to have achieved about the right balance to prolong the current cycle. Yes, the cycle is long in the tooth, but without the visible froth of excess risk-taking that typically sows the seeds of the next downturn, the end of the cycle does not appear near. Amid a return to synchronised easing on record levels of global debt, we will watch for the froth that will eventually emerge to break the cycle.

Asset Class Hierarchy (Team view1)

Asset Class Hierarchy (Team view1)

* Total scores for Equity, Sovereign and Credit are weighted average scores, which are computed using market cap weights.

1The asset classes or sectors mentioned herein are a reflection of the portfolio manager’s current view of the investment strategies taken on behalf of the portfolio managed. These comments should not be constituted as an investment research or recommendation advice. Any prediction, projection or forecast on sectors, the economy and/or the market trends is not necessarily indicative of their future state or likely performances.

Research Views

We make adjustments to our asset class views and hierarchies as discussed below.

Global equities

The resumption in US-China trade talks and impending monetary easing are supportive of a more constructive view on equities than the neutral positioning we adopted last month. The key watch point for equities is, as always, earnings and the impact of recent uncertainty on earnings is something we are watching very closely.

As we discussed in this report last month, we believe the macro backdrops in both the US and China have deteriorated for reasons beyond the trade skirmishes. It is not just the ongoing weakness in headline growth numbers that is a concern. The larger concern remains around the limited capability of both the government and the consumer to spend their way into higher economic growth. Liquidity has eased somewhat but remains tight. We may need a few rate cuts before it again becomes a tailwind.

Hence a rotation of regional equity allocations might be a more prudent way to dial up risk than an outright increase in equity exposure. We take this approach through an upgrade of domestic China-A shares, Australia and Canada to the top of our equities hierarchy. All three are likely beneficiaries of the strengthening credit impulse in China. Our constructive views on Australia and Canada are also underpinned by the stabilising of their domestic property sectors (see Chart 1 and Chart 2) and from a bottoming in energy and commodity prices.

Chart 1: Australia combined 5-cities home values (% monthly change)

Chart 1: Australia combined 5-cities home values (% monthly change)

Source: Bloomberg, June 2019

The Australian dollar has weakened by 5% in the last 12 months, while the Reserve Bank of Australia has cut rates to a historic low of 1%. Both of these are supportive of the domestic equity market which continues to enjoy the strongest price and earnings momentum across developed market equities globally.

At the other end, ongoing Brexit uncertainty encourages us to keep UK and Europe equities at the bottom of the hierarchy.

Global bonds

The strong rally in global bonds over the last few months has been the proverbial rising tide that lifts all boats. While Canadian government bonds have certainly benefited from this, they have not been able to keep up with stronger performing markets elsewhere. As a result we have downgraded Canada to a neutral weight.

Earlier in the year, Bank of Canada Governor Stephen Poloz outlined three main concerns that were holding back the economy: weakness in housing, low oil prices and global trade uncertainty. We certainly have no qualms about the Bank’s concern for housing as new home prices fell precipitously in 2018. This weighed on consumer sentiment last year, but as house prices have begun to stabilise in 2019 so has sentiment. More recent readings have seen a resurgence in consumer optimism.

Chart 2: Canada housing prices and consumer sentiment

Chart 2: Canada housing prices and consumer sentiment

Source: Bloomberg, June 2019

As a major oil and gas producer, Canada’s economy is also sensitive to conditions in energy markets. In this regard, oil prices have recovered from a nasty fall below USD 50 a barrel last year to provide much needed relief for Canadian producers. This recovery has no doubt been welcome, however it has also fed into higher inflation. The Bank’s median measure of core inflation has risen this year and now sits above its inflation target of 2%, one of the few developed countries where this is the case.

Chart 3: Canada core inflation and oil prices

Chart 3: Canada core inflation and oil prices

Source: Bloomberg, June 2019

While US-China trade negotiations have dominated investor attention, Canada has had its own trade issues closer to home. Uncertainty over NAFTA negotiations and the imposition of steel and aluminium tariffs last year were a significant concern for businesses. More recently, though, the trade news has been positive as an agreement with the US and Mexico has been reached to replace NAFTA, and the US has removed the tariffs on Canadian steel and aluminium. So not surprisingly, with better news on all three of the concerns laid out by Governor Poloz, the Bank is more positive on its economic outlook and not likely to follow the global easing trend in the near term.

Global credit

As central banks around the world prepare to ease, credit markets can rest easier as the anticipated rise in liquidity lifts the tide so that those not wearing the proverbial bathing suit can comfortably swim while remaining unexposed—at least for the time being. Between newfound liquidity and the quest for yield, credit spreads can be expected to compress—and they have.

Mario Draghi upped the ante in mid-June, surprising markets in a speech where he dovishly stated the bank’s willingness and ability to inject stimulus should it be required, firmly pushing out rate hike expectations and opening the door to potential rate cuts. Credit spreads that had been threatening to widen over the last year due to an increasingly grim economic outlook soon collapsed to mid-2018 levels after Draghi’s speech. Once again, any value-based opportunities quickly evaporated. We were neutral European credit before Draghi’s speech on weak fundamentals supported by some degree of value, and we are neutral today for poor risk-reward characteristics while acknowledging that easing can push out any concern on deteriorating credit conditions.

Chart 4: European investment grade spreads (iTraxx Europe 5-year credit default swap)

Chart 4: European investment grade spreads (iTraxx Europe 5-year credit default swap)

Source: Bloomberg, July 2019

We still prefer Australia credit for better value relative to more conventional monetary policy, and the outlook for US credits is also reasonably attractive. Despite some deterioration of corporate profits, they are still in better shape than during the downturn in 2015 that was followed by more rate hikes, in contrast to the rate cuts that are currently anticipated.

FX

While the USD was steadily lifted up the hierarchy in recent months, culminating in it reaching the top last month, we have brought it back down partially on news of the trade truce, which eases pressures on China and (more broadly) emerging markets. There are also broader fundamentals that suggest the dollar can further weaken from here.

The principal driver of USD strength had been the US’s relative growth advantage over the rest of the world, driven by fiscal stimulus in early 2017. This was accentuated by the slowdown in the rest of the world on the back of China’s tightening and the escalation of trade wars.

In fact, the pick-up in US growth, as defined by economic activity, has fully dissipated in 2Q19 to levels that preceded the US stimulus, meaning that the dollar tailwind of capital flows is likely to dissipate as well. Moreover, while China stimulus has been slow to feed into growth, steady adjustments and small increases to stimulus bodes well for better growth in 2H19.

Chart 5: US excess growth over the rest of the world

Chart 5: US excess growth over the rest of the world

Source: Bloomberg, June 2019

The Federal Reserve (Fed) pivoted dovish late last year, but the bond rally accelerated in 2Q19, quickly pricing in three rate cuts and causing the yield curve to invert. The dovish turn has not only been a tailwind for bonds, but also gold as central bankers appear to be preparing to debase currencies with the hope of taking market share of the relatively anaemic trade volumes. Of course, this is a zero-sum game where there are no clear winners except perhaps gold, which remains a store of value.

In fact, while bonds have rallied, gold has rallied even more. Chart 6 plots the relative performance of bonds versus gold; this relative performance also tends to track the performance of the USD. When gold outperforms bonds as has been the case recently, it is a sign of potential reflation, or at least a rising risk of inflation, that tends to weaken the dollar. As growth in China picks up in 2H19 and central banks around the world begin to ease, it is not hard to anticipate reflation.

Chart 6: Relative performance of bonds versus gold and performance of USD index (DXY)

Chart 6: Relative performance of bonds versus gold and performance of USD index (DXY)

Source: Bloomberg, June 2019

Commodities

We raised broad commodities above gold this month, partly for the speed of gold’s run-up into rich valuation territory and also due to the rising probability that markets have may have gone too far in pricing in Fed rate cuts, which would tend to lift yields and be a near-term headwind for gold. Moreover, China announced new stimulus in early June—this time directed at infrastructure investment. We do not expect any major boost in demand, but it should improve at the margin.

Gold caught investors’ attention in June, gaining 8%, breaching the key resistance level of USD 1350 per ounce, and finishing the month above USD 1400. Near-term, gold could give back some of these gains, particularly if yields rise. However, over the longer term, the move to synchronised monetary easing adds to its appeal as a store of value.

Importantly, as a larger portion of the bond market is pushed into negative yielding territory, the relative cost of carrying gold declines. As shown in chart 7, when negative yielding bonds rise in price through negative yields turning more negative, investors also bid up gold. On a risk-reward basis, the preference for gold over negative yielding bonds simply makes sense should there be any growth or inflation surprise to the upside.

Chart 7: Gold versus negative yielding debts

Chart 7: Gold versus negative yielding debts

Source: Bloomberg, July 2019

Demand for base metals and energy should also improve due to stimulus in China, but also on reduced uncertainty as the US and China get back to the negotiation table. The supply outlook is also positive for energy, as OPEC+ agreed to extend production cuts by nine months and committed to reduce inventory levels in developed countries. Falling oil inventories for the first time this year in the US are also an encouraging sign for energy prices.

Chart 8: US crude oil inventories

Chart 8: US crude oil inventories

Source: Bloomberg, July 2019

Process

In-house research to understand the key drivers of return:

Process