A. Four new themes for 2Q2019

• We introduce four new investment themes, with the first being the “US Fed’s patient policy”. Following some conflicting signals in recent months on the US economic data, it is prudent for the Fed to exercise some caution. Although much of the domestic economic data unveiled was solid, yet some surveys on business and consumer sentiments have shown the indicators are trending lower. Besides, growth slowed in countries like China and Europe while uncertainty remains around some unresolved government policy issues like Brexit and ongoing trade negotiations.

• Our second theme is “China has moved to easier credit and fiscal policies”. In line with our view, the Chinese have exercised a greater level of caution this time around as opposed to during the 2015–2016 downturn. The Chinese government announced cuts in taxes and fees worth nearly 2 trillion yuan (US$289.28 billion) that should see the 2019 government’s budget deficit widen to 2.76 trillion yuan or 2.8% of GDP. It will be further supported by accommodative monetary policy and a more stable yuan.

• In our third theme, the supportive stance of global policymakers should underpin both equities and bonds. Still the “strength of the global markets across looks fragile and hard to replicate”. Expectations of the US Fed monetary policy are dovish. There is a need to strike a balance between risk and reward. With signs of slower growth or risk of new trade disputes emerging, there is enough room to potentially stoke uncertainty.

• Our final theme is the “trade war”. Just as the US is said to be finalising a trade deal with China, the worry is over possible US tariffs on European goods worth US$11bil. In particular, it will be on European cars and auto parts that are stoking a lot of tension. While China has a strong pipeline of stimulus measures to counter the slowdown, the eurozone has limited room. Also, there could be tariff slaps on countries. So, it remains a potential concern on the damage to be wreaked by tariffs, especially with the global economy moderating.

1. What could likely trigger a US recession?

• It is natural to form a view that the US economy is in the late-stage of the business cycle. Like us, many are focusing on the timing of the next recession. The current expansionary business cycle that started in June 2009 is in its 117th month and should surpass the longest such cycle on record of 120 months (March 1991 to March 2001).

• Since the current cycle has lasted double the average, concerns are that this expansion would end soon. More so, though the yield curve has recovered from its brief inversion, the gap is narrow, suggesting the risk of the economy falling into recession over the next 12–18 months (and not earlier) is still there. Given that visible inflationary pressures will probably not build up much over the medium term, this would mean the Fed is unlikely to switch its policy into “inflation fighting” from “growth nurturing”.

• What can trigger the next downturn is more specifically a sudden and sharp "flight to safety" after fundamental weaknesses in financial markets are revealed. The current near-inverted yield curve, low nominal and real bond yields, and equity values suggest that the US financial markets may have begun to price in the likelihood of a recession. Should the business investment committees and consumers also take a similar view, it could trigger a recession, especially from the retrenchment of investment spending.

• So, the nature and form of the next financial shock will come from unanticipated events, since investors, speculators, and financial institutions generally hedge against the foreseeable shocks. For example, the 2008 global financial crisis came not from the collapse of the mid-2000s housing bubble, but from the concentration of ownership of mortgagebacked securities. The long downturn of the early 1990s was not directly due to the deflation of the late-1980s commercial real-estate bubble but due to the failed regulatory oversight that allowed insolvent savings and loan associations to continue speculating in financial markets. And it was not the deflation of the dot-com bubble that triggered the recession in the early 2000s, but rather the magnitude of overstated earnings in the tech and communications sectors.

• On that note, the bets on the likelihood of the Fed possibly instituting a rate cut — a U-turn from its current policy cannot be ruled out. Federal funds futures are currently pricing in a 40% chance of a rate cut by December 2019. If a rate cut does actually take place, it need not necessarily mean that the economy would head for a “real” recession. For now, we project the 2019 GDP at 2.1% and inflation at 1.8%.

• With a dovish Fed outlook, we foresee a weakening trend on the USD. The USD fell 0.80% YTD and is indeed overvalued. We expect the currency to settle around the 92–93 levels by end-2019 with a 5% risk. Meanwhile, there is a disconnect between treasury yields (real and nominal) and the economic outlook. Room for volatility remains highly present, coming from the interest rate noises to asymmetry news.

• So, a gradual steepening of the yield curve driven by still-solid US growth with a view that the Fed will tolerate an overshooting inflation is envisaged. Hence, we are cautious on US Treasuries although we still see them as portfolio diversifiers given their negative correlation with equities. With the expectation of a shift in the Fed’s balance sheet towards shorter-term maturities, it should support two-to-five-year maturities and inflation-protected securities.

2. Europe faces political and policy uncertainty

• Although the eurozone economy is expected to remain “fragile”, we found the region to continue stabilizing. While manufacturing is struggling, the services sector is supporting the economic performance. While the economy appears to be losing momentum, its sliding momentum is softening, suggesting the region could possibly prevent a deeper downturn. And with the US and China still in the upswing, it can act as a positive feedback to roll into Europe in the coming months.

• However, the “fragility” of the economy remains. More so now with the trade talks between the US and Europe. It could put forth a US$11 billion list of tariffs against the EU. Some of the import duties would include both soft and hard commodities ranging from wine and various cheeses to helicopters and industrial parts. The dispute first emerged in 2004 – and still has not had a definitive ruling – when the US brought the matter to the attention of the WTO which outlined how the EU’s subsidies negatively impacted US commerce.

• Besides, confidence has taken repeated blows from a row of disappointing data on several of the eurozone’s biggest economies, particularly that of Germany, its powerhouse. Germany accounts for about 29% of the region’s activity. Weakness in Germany will drag euro growth although some of the countries here did not lose momentum to any great extent so far, like Spain. But Italy fell into a recession in 2018. However, the economy is smaller than it was before the financial crisis a decade ago.

• Mounting pessimism over the region is driven by the European Central Bank’s (ECB) decision to further adopt a looser monetary policy. On March 7, the ECB announced a new targeted longer-term refinancing operation (TLTRO) that will run from September 2019 through March 2021, thereby providing full funding through 2023. The ECB also left rates unchanged through the end of 2019 and committed to reinvest the principal payments from maturing securities.

• Can the ECB do something more? It depends on the next president after the May European elections. It remains unclear if the next leader will remain dovish as outgoing ECB President Mario Draghi or otherwise. And the ECB has little ammunition left. Interest rates are at or close to the lowest level they can be. Its main rate is zero and one – the deposit rate for money held overnight for commercial banks is even lower; it is negative. The ECB can revive its "quantitative easing" policy that was stopped at end-2018. But there are complications. Some types of assets have reached the maximum amount the ECB wants to hold to avoid distorting the market too much. Politically, it can be difficult especially with Germany where it views QE with unease.

• On the governments, the option is to stimulate economic activity through tax cuts or increase spending. While Germany has the scope to do that, other governments have less room. Meanwhile, Germany is reluctant to use its finances as a stimulus. Also, there are legal restrictions in the German law and the whole eurozone policy on government finances.

• We are looking at a GDP growth of 1.2% in 2019 with inflation also at 1.2%. With signs of a weakening euro, the currency has been dragged down by 1.4% against the USD thus far this year, after falling by 4.5% in 2018 compared with the US dollar index, which is made up of six major currencies including the euro, weakening by a milder 0.8% thus far in 2019.

• Potential weakening signs of the euro against the USD remain as some of the more specific risk factors like the US tariffs on EU autos, EU election risk, and Italian sovereign debt have not been priced in. On that note, the euro is currently undervalued largely because the USD is overvalued and could reach around 1.16 against the USD. In our estimation, we factored in a 2%–3% volatility against the USD.

• In the meantime, with political risks, low yields and the potential reassessment of an easy ECB policy or pessimistic euro area growth expectations, it will continue to cause wariness on European sovereigns. Thus, we remain cautious on exposure to the longer-duration bonds. We are cautious on Germany and France.

3. UK’s outlook dependent on how it leaves EU

• The economic outlook for 2019 and beyond depends on how the UK leave the EU and the path that it follows thereafter. A benign, transitional exit would likely see an acceleration in UK activity in 2019, projected to grow around 1.8%. But such a transitional exit is far from guaranteed though the UK and EU would clearly steer away from a more abrupt withdrawal. However, a miscalculation may result in that outcome, meaning there would most likely be materially adverse consequences for the UK economy. We are looking at a growth of 1.1% in 2019.

• In the case of a no-deal without transition, business spending would weaken as firms increase overseas investment. The sterling would fall further, generating inflation and weighing on consumer spending. Exports would also struggle as trade was no longer covered by the EU’s FTAs. Some of the key sectors of the economy would be especially hard hit by a messy Brexit. Sectors like the auto, chemicals and pharmaceutical industries, which trade heavily with the EU, would shrink more than 20% over the long run.

• Yet, looking beyond the short-term uncertainty, the UK may find that whatever the outcome, the environment could become all the more difficult as global economic activity materially wanes in 2020, as risks of a pernicious global downturn grow. So, we feel that beyond Brexit, the UK growth will be governed by a re-synchronisation with the global cycle. Material deceleration in US economic activity and more modest slowdowns in China and Europe will leave demand growth for UK goods and services softer.

• In a gentle post-Brexit path, the UK will have sufficient idiosyncratic pent-up demand to buck the global trend in 2019 and 2020. We forecast the catch-up in investment spending, stronger consumer spending and easier fiscal policy to offset the worsening global headwinds that will tighten financial conditions and worsen net trade. So, the GDP should be at 1.1% in 2019, still in excess of the trend despite the global deceleration while inflation is at 1.8%.

• However, in the event of a damaging Brexit, a material supply-side shock may only begin to ease in 2020 as ports increase capacity to cope with the necessary customs checks. While the UK economy might begin to post a tentative recovery in growth, it would do so from a more enfeebled position and it would not be as well placed to withstand the expected slackening of global growth.

• While the Bank of England (BoE) has warned that it would assess changes in demand, supply and the exchange rate before judging the correct course of monetary policy, an abrupt exit is likely to warrant a modest easing in monetary policy. Interest rates should fall back to 0.25% with the prospects of QE before the end of 2019.

• Equally, a Brexit deal that results in economic acceleration, further above the trend in an economy that the BoE already assessed has closed its output gap, points to a need for more policy tightening. We expect the BoE to resume its tightening policy with the final hike to reach 1.50%–1.75% by 2020.

• A more cautious approach to the sterling is warranted although the market has a bias towards pricing in a soft deal. This is reflected by the sterling’s performance this year which outperformed its rivals i.e. the best performing G10 currency as markets have priced out a no-deal Brexit and there is no great appetite for such an outcome except to back a delay. Despite the extension, there remains a risk of a no-deal Brexit. And if this were to transpire, the sterling would fall steeply since the market is not positioned for such an outcome.

• Despite the clear risks, an orderly Brexit will eventually be achieved. On this scenario the EUR/GBP should settle in 0.85 to 0.86 and 1.37 against the USD. On a hard Brexit, the EUR/GBP should spike towards parity, and against the USD should plunge towards the 1.13 area.

• Looking at bonds, the ongoing Brexit saga will continue to result in uncertainty, now extended until October 31. With clouds of uncertainty continuing to hang over the Bank of England, we remain neutral overall during this duration in the UK, expecting a range between 1.0% and 1.6% over the next 12 months.

4. Need for BoJ to rethink policy

• Recent data has shown that the economic expansion is waning in parts of Europe and China. With the economic slowdown in China and some other countries, it is expected to weigh on Japan’s exports and production although the economy is poised to grow modestly. And the new challenge will be the trade talks between the US and Japan. We are looking at a 1.0% GDPgrowth for 2019 and inflation also at 1.0%.

• Underpinned by uncertainty over the global economic outlook, the US Fed and the eurozone freeze their plans to raise interest rates. Japan has also been affected. Its latest expansionary phase, claimed by the government to be the longest since the end of World War II, may have already ended in late 2018. Thus, the central bank decided to maintain its monetary policy of asset purchases and ultralow interest rates and measures aimed at lifting stubbornly low inflation.

• The BoJ has continued aggressive monetary easing since April 2013 in pursuit of a 2% inflation target to dispel deflationary woes. In September 2016, it changed its policy framework from expanding the monetary base to targeting interest rates. But inflation remained below 1% as tepid wage gains keep households from spending.

• At the moment, there are no changes to the BoJ’s policy of aiming to bring about stable prices while considering the economy, prices and the financial environment overall. It is still sticking with the 2% target. But with policy side effects piling up, we feel there is an urgent need for the BoJ to rethink its commitment to the 2% inflation which appears to us as unrealistic.

• Being a safe haven, its attraction will depend on the risk appetite. While trade talks between China and the US seem to be coming to a conclusion, near areas that risk trade war with the US are euro and Japan. So volatility is expected as we move along and project the yen to settle around 108 against the USD.

5. Emerging Asia may have bottomed and start to improve

• Economic growth in emerging markets (EMs) may have bottomed and could start to improve gradually although growth in some EMs faces some headwinds. However, the drag on EMs growth will be much smaller compared with most advanced economies. Cyclical indicators like fiscal and current account balance remain well behaved. There is a lack of inflationary pressure.

• Policy renormalization from advanced countries’ central banks suggests their rates are expected to stay below the neutral policy rate. The Fed is signaling a lengthy pause in its tightening cycle while the ECB is extending its targeted lending programme with rate hikes more likely to happen sometime in 2020. It should lessen the headwinds in EMs. So, the EMs will have better long-term profit growth.

• A more dovish US Fed outlook and almost concluding trade-related issues between the US and China have significantly diminished the US dollar’s appreciation bias. It also reduced the drivers of the yuan depreciation as well as many other emerging market currencies. As such, it has eased the risk of emerging market crisis from flaring up, especially those with large short-term US dollar-denominated debts.

• While there are positive macroeconomic factors for EMs as a whole, there are significant divergences between countries. For instance, Argentina and Turkey remain vulnerable to economic shocks. Meanwhile, South Korea can now be considered more developed than some of the smaller developed countries like Portugal.

6. China’s modest stimulus measures

• China’s growth should remain above the 6% critical level. We are looking at a 6.2% GDP for 2019 supported by modest stimulus measures both fiscal and monetary in response to the trade tariffs. Inflation is projected at 2.2% for 2019. The Chinese have embarked on a number of cuts to the amount of cash that banks need to hold in reserves, in an effort to get more money into the real economy through bank lending. Also, a new round of major infrastructure projects and the announcement of a 2 trillion yuan (US$298bil) tax cut package should support the economy.

• The modest fiscal expansion augurs well and will help avoid a sharp slowdown. Any strategy to embark on an excessive stimulus messures to support growth through looser credit standards, a resurgence of shadow banking activity and offbudget infrastructure spending will heighten financial vulnerabilities, reduce future policy space and raise downside risks to medium-term growth.

• Besides, the outlook for the US-China trade tensions has improved as the prospect of a trade agreement takes shape. These responses have helped reverse the tightening of global financial market conditions to varying degrees. Recent incoming data such as construction machinery industry, purchasing managers' index for manufacturing sector, consumer prices and foreign trade shed some light, suggesting the economy is unlikely to fall into a tailspin.

• With growth supported by moderate stimulus measures, added with softer inflation plus a near conclusion of the USChina trade disputes, the yuan is unlikely to appreciate fast against the USD. We expect the currency to settle around 6.60 against the USD.

7. Monetary Authority of Singapore to likely stand pat

• A stable currency is expected to lend support to the weakening external sector over the coming months especially as the Monetary Authority of Singapore (MAS) has decided to stand pat on its monetary policy by keeping the slope, width and centre of policy bands unchanged.

• With the US Fed being dovish, it should see the SOR and SIBOR remaining stable. This will boost the construction sector which witnessed the first quarter of positive growth (1.4%) in 1Q2019 following 10 straight quarters of decline.

• Moreover, the fiscal stimuli unveiled during the budget address in February will also help strengthen domestic demand following the government’s generous transfers to citizens. Given the expansionary fiscal plan, it should register a small fiscal deficit in FY2019/20 of around 0.4% of GDP, which will bode well for domestic consumption. Hence, the dismal 1Q2019 GDP of 1.3% should start to improve in 2Q2019.

• We expect the GDP to grow around 2.3% for 2019 on the back of weaker export growth in view of moderate global growth and a maturing tech cycle. With slower growth and softer inflation projected at 1%, we expect the MAS to maintain its current monetary policy stance.

• As such, the Singapore dollar’s nominal effective exchange rate (S$NEER) is unlikely to appreciate sharply as it is already trading close to its upper band. The stabilisation of the currency will be a relief for exporters as it remains fairly valued at current levels. Room to ease its monetary policy in the October meeting is there if growth continues to undershoot.

8. Moderate growth for Malaysia

• The economy should bounce back in 2H2019 after it was expected to register the lowest 1Q2019 GDP by taking into consideration the recent data. It should be the slowest quarterly expansion since 2Q2016. The Brent posted its best quarterly performance in a decade since 2Q2009. Though our base case oil projection for Brent is US$62–65 a barrel on average, if the current trend persists, it could touch our best case which is US$65–68 a barrel on average for 2019. The WTI is projected to trade at around US$5 per barrel discount against the Brent.

• Besides, the economy is expected to benefit from the kick-starting of 121 construction projects that were valued at RM13.93bil by the Pakatan Harapan (PH) government after having saved RM805.99mil. These exclude mega projects like the Light Rail Transit 3 (LRT3) now costing RM16.63bil and Mass Rapid Transit 2 (MRT2) RM30.53bil from their original costs of RM31.65bil and RM39.35bil respectively. Cost savings from both the projects amounted to RM23.84bil. Also, the revival of the ECRL project that now costs RM44bil from RM65.5bil previously, added with the Penang Light Rail Transit and the Pan Island Link 1 will provide positive impetus to growth.

• Furthermore, with the government’s commitment to consolidate its fiscal consolidation, it implies that private expenditure will continue to spearhead growth. While the public sector undergoes rationalization and exports moderating despite supportive measures from China gaining traction and should somewhat cushion our softening exports, the policy measures will continue to support private spending. Hence, the 2019 GDP should grow around 4.5% for 2019 with 1H2019 likely to average at 4.2% and 2H2019 at 4.8%. Inflation is projected at 1.0% for 2019.

• With slower growth and softer inflation, the monetary policy will remain accommodative. Room for monetary easing biasness remains, especially if business and consumer sentiments remain weak. As such the ringgit against the USD is unlikely to appreciate sharply vis-à-vis its regional peers. We expect the ringgit to be around 4.10. With the currency still being undervalued against the USD, it should provide relief for exporters.

• On the bond segment, despite EMs growth facing some downward pressure, the risk is low with increasing signs of stabilization. Cyclical indicators such as fiscal and current account balances remain well behaved, with lower inflationary pressure providing room for monetary easing. More so with the US Fed pausing on rate hikes and the ECB extending its targeted lending programme. It will soften the economic headwinds in emerging markets while easing US dollar appreciation and reducing the driver of the yuan’s depreciation.

• But clear risks include deteriorating US-China relations and slower global growth. So we remain neutral with focus on quality papers in investment grades in India, China and high yields in Indonesia. At the same time, we are cautious on the Chinese government debt despite its inclusion in global indexes from April as we see rising funding needs outstripping foreign inflows.

• Malaysia’s bond yields will be supported by healthy macro fundamentals like steady growth, healthy reserves, current account surplus, low inflation and real money flows. We expect the gross issuance of MGS/GII in the primary market for 2019 to hover around RM120bil and RN125bil while the corporate bond and sukuk market is expected to see a total issuance of RM80–85bil. We project Malaysia’s 10-year MGS yield at 3.75%–3.80% as our “prudent” levels with room to reach 3.70% if a 25bps OPR rate cut is instituted. In the event there is no rate cut, we expect the 10-year yield to move back to our original levels of 3.90%–4.00%.

Source: AmInvest Research - 18 Apr 2019