Weekly Market Analysis - Asked and Answered – Your Top of Mind Questions on Investments

Our View: Chinese Equities have Bottomed

The recent rally is well supported by macro data, property and tech policy easing, capital market reforms and fund inflows from government and private sources. Several structural problems we’re watching have not been addressed but may be mitigated. The longevity of the rally would depend on a potential rebound in earnings growth as current valuations remain historically low. We believe that China is returning to a more normal range of valuations after the worst bear market in two decades. This is because the domestic policy and macro backdrop has stabilized, which could enable the return of earnings growth. Structural impediments and external risks remain but investors could still find lucrative opportunities as we potentially enter a stable era for China equities.

So far, earnings remain in the doldrums. 2023 annual reports gave no hints of stronger corporate outlooks. Consensus estimates were revised lower year-to-date for all sectors except Consumer Discretionary, which reflected the recovery in travel and leisure. First quarter results are being reported now, but recent policy shifts are unlikely to be reflected in these numbers until the next quarter. Looking at past several rallies, those that were followed with earnings growth (2009-11, 2016-17, 2020-21) lasted one to two years, while those that weren’t supported by earnings (2014-15, 2022-23) fizzled out in about six months. Still, the price to pay for a potential return to earnings growth in China remains historically low.

TRADE WAR IMPLICATIONS: Tariffs and defense alliances could differ widely post November, depending on which nominee wins the US Presidential election. Potential changes will have to be discounted by investors. Candidate Trump has again pledged large tariff increases that might amount to as much as 2% of US GDP, paid for by importers of foreign goods and some services. This includes a 60% prospective tariff on China and 10% for all other trading partners, regardless of existing tariff agreements (please see the section above on China’s US trade share). Like 2018, its imposition is likely to lead to tit-for-tat retaliation. President Biden is also reportedly considering severe but more targeted tariffs on electric vehicles along with other key clean energy materials. This is not, however, where the largest risk lies. It’s consumer price and inflation expectations in a world that has recently experienced negative, and sometimes crippling, consequences of higher inflation. In our view, portfolios should be constructed for a range of possible positive and negative outcomes in mind, not just the highest returns. Growth amid concerns over trade continuity, civil unrest, security risks and technological possibilities - such as a state-sponsored cyber-attacks - call for a combination of higher and lower risk investments in portfolios. Fortunately, growth and solid yields for safer income now coexist (please see last week’s bulletin). We have also argued for hedging portfolio risk as hedging costs are historically low.

Russia-Ukraine: Limited Impact on Global Markets

Russia’s expected counter-offensive in the summer of 2024 could worry investors. The hope is that the provision of supplementary military aid and financial assistance to Kiev will avoid a negative scenario. The risk of escalation remains sizeable and would most likely weigh on the euro and dampen appetite for European assets after a period of positive surprises for the region. The lasting focus on deterring Russia may ultimately boost defense shares. But what will it mean for global markets more broadly? As we’ve showed previously, geopolitical shocks and threats to security have generated remarkably few cases of lasting impact on a global scale. Only the advent of World War II and the OPEC embargo 50 years ago catalyze a negative turning point in the world economy.

Don’t Sell in May and Go Away

While the third quarter of the year tends to exhibit the poorest seasonality, strategies that attempt to avoid potential summer selloffs have a mixed track record. The famous adage “sell in May and go away” is based around the fact that the best six months for US equity returns tend to be between November and April. However, an investor who actually heeded this advice over the past 34 years and moved into cash from May to October would have underperformed by about 1.4% per annum.

US ELECTION-RELATED VOLATILITY: Historically, volatility has indeed picked up into US Presidential elections, often peaking just beforehand, and then it has receded. Since this is often temporary, many investors with longer-term time frames may choose to simply endure the ups and downs. That said, the first line of defense is a balanced and diversified portfolio comprised of investments that do not move precisely in lockstep. With some US investment grade bond coupons yielding literally 10X the record low of 2020, we should be expecting the correlation of stocks and bonds to be coming down from the pandemic period. This should allow asset allocation - the combination of low-risk bonds and high-risk equities – to yield stronger risk-adjusted returns.

Finally, suitable investors may want to consider an allocation to IG preferred securities. Yields for these IG securities are currently slightly higher than the BB-rated high yield index. Additionally, depending on structure, many of the US-based preferred issues’ interest distributions are taxed as dividend income, which can have a preferential tax rate for certain US taxpayers, and so potentially increases the pre-tax equivalent yield.