The China Deal is Coming

Sébastien Galy, Senior Macro Strategist at Nordea Asset Management

As we enter 2019, many investors are eager to put 2018 in the rearview mirror for good. But the US trade deal (or trade war, depending on your perspective) with China continues. Irrespective of your opinion, strip away the rhetoric surrounding Donald Trump and you find a savvy American president who understands his electorate and prevails with an incredibly narrow base equivalent to roughly a quarter of the US population. With a large and persistent trade deficit and an aggressive style, he is likely to succeed in forcing China into a favorable trade deal. The current government shutdown negotiations are a good indication of what we will see with China. The odds are that negotiations will take up to a month before the economic toll becomes a problem for his Republican base. Economic activity is damaged by the process but ultimately Trump will get partly what he wants as the vast majority of government employees are Democrats. Likewise, it’s not improbable we could be looking at a trade deal with China around September, late enough to still have an impact on the Republican primary debates.

What does this mean for investments?
The probability of a late China deal affects our asset allocation by benefiting Emerging Market (EM) debt and equity, as well as European and US equities given their exposure, starting at some point in Q1. This should be triggered by two events: first, the realization that a China deal is virtually a certainty and second, when the market stops reacting to negative news from China. While professional investors realize that official data plays some catch-up to events on the ground, retail is surprised. Furthermore, China is likely to be the leitmotiv to explain missed earnings as were previous themes such as inadequate currency hedging. Having said that, bottom-up earnings are likely to show the China impact and higher input costs. Till then, we remain in a difficult environment with volatile equities and underperformance until we reach this kinking point largely determined by China.

We remain positive on low volatility equity, as well as risk premia investing or long-short strategies. Why? A bad year for equities in 2018 has built a base for 2019:

Earnings growth peaked and lost steam in 2018 with 2019 forward guidance down on the back of an expected slowdown and higher input costs. Retail is yet to price this fully relative to the China factor. This is reflected in a large fall in P/E combined with lower asset prices. Consequently, this is building good intrinsic value especially for lower risk equities

Volatility spiked at the end of 2018 amid low volume and should stay elevated.
Volatility spiked up to 36%, levels comparable to 2011, 2015 …, and we forecast an elevated level or mid regime of 12%-25% for 2019 driven by lower growth and large leverage in the High Yield space with likely rising default risk as well as political risks. One key factor is that the Fed has been tightening, though this may stop in 2019 against a Fed forecast of two more hikes. This means that equities with a lower volatile profile might be in favour in 2019 along with some moderate selectivity/management in EM once a China deal starts to be priced in. Beginning of 2019, it will be interesting to see how asset allocators position themselves. This typically leads to a trend that is squeezed a few months down the road. As of now, long EM seems to be a common theme given cheap valuations, high yields and hopes of a China trade deal.

• The losses in 2018 may taint the size of capital put at risk
• A fading outlook suggests lower returns
• The Fed is unlikely to hike twice and we could see a flattening/maybe reversing yield curve
• Persistent world trade turmoil is driven by the negotiation tactics of the US government which generates volatility until some point in Q1 when the market will anticipate the shape of the deal
• Late credit cycles, especially in the High Yield sector in the US, but also in China, contribute to equity volatility.

There doesn’t seem to be a market consensus concerning a recession in the short to medium term. Thus, lower risk and lower beta stocks and/or outcome solutions, such as risk premia investing or long-short strategies, might be favored.

In the bond market, we prefer EM, EU to US High Yield, while EU debt for US investors is attractive

High Yield spreads spiked at year end creating some value in junk bonds with predicted low defaults, however:

• Credit spikes also signal upcoming fears from stretched fundamentals/late cycle and quality of earnings
• Oil drop (20%) hurts corporations in that sector which accounts for 15% of US High Yield market. They burn cash the longer oil prices stay at such low levels. OPEC aggressively cut output but demand is surprisingly weak and may stay that way.
• The leverage is an issue of prolonged loose monetary policy particularly in the High Yield sector and is vulnerable to rollover and duration issues as the Fed tightens, though hopefully this should stop.
• The correlation between interest rates and credit yield somehow worked nicely in recent months offsetting the rise in credit spreads.

The cost of currency hedging in EUR/USD spiked to historical highs of more than 300bps:

• This opens interesting opportunities for US investors to position in the EU on a currency hedged basis. A likely weaker dollar on the back of the Fed staying on hold should benefit foreign investments by US investors on a partially currency hedged basis. In addition, China’s currency diversification should support EUR/USD.
• We prefer EU to US high yield given the higher probability that the ECB stays on hold while a little tightening is already expected in the US. More importantly, the leverage is also much higher in the US and in some cases structural forces are at work leading some companies into restructuring. Persistently low oil prices would also eventually hit US High Yield hard.
• EM Debt should be supported by a weaker dollar and a reversal of flows on the back of an eventual China deal and a further three cuts to China’s RRR. Nonetheless, selectivity suggests managed EM funds.

The upcoming China deal
China and the US reached a ceasefire on the 90-day deadline after China promised to buy a very substantial amount of US goods, all good intentions while Soybean imports completely collapsed. Both China and the US know that the deal needs to support the US President’s 2020 bid. The end date is likely Q3 as the first debate will be starting by year end and the first primaries are in February 2020. Another consideration is that viewership peaks in Q1 and Q4. Net net, this suggests September when people are back from holidays as the most likely date. From a bargaining point of view, the US has given the list of what it wants and the Chinese are slowly starting to do the same. The negotiations then typically diverge before rapidly converging at the close. The trick therefore is to find the likely date of completion and in particular, the moment when the market will start to consider that it is a done deal and only a matter of time— Q1 by our guess.


About Nordea Asset Management
Nordea Asset Management (NAM, AuM 216.8bn EUR*), is part of the Nordea Group, the largest financial services group in Northern Europe (AuM 311.5bn EUR*). NAM offers European and global investors’ exposure to a broad set of investment funds. We serve a wide range of clients and distributors which include banks, asset managers, independent financial advisors and insurance companies.

Nordea Asset Management has a presence in Cologne, Copenhagen, Frankfurt, Helsinki, London, Luxembourg, Madrid, Milan, New York, Oslo, Paris, Santiago de Chile, Singapore, Stockholm, Vienna and Zurich. Nordea’s local presence goes hand in hand with the objective of being accessible and offering the best service to clients.

Nordea’s success is based on a sustainable and unique multi-boutique approach that combines the expertise of specialised internal boutiques with exclusive external competences allowing us to deliver alpha in a stable way for the benefit of our clients. NAM solutions cover all asset classes from fixed income and equity to multi asset solutions, and manage local and European as well as US, global and emerging market products.

*Source: Nordea Investment Funds, S.A., 30.09.2018

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