Fixed income products produced positive results in August. The Bloomberg Barclays Global Aggregate Bond Index rose 2.03%, US Investment Grade, Emerging Markets US dollar Bonds, and US High-yield bonds rose 3.14%, 0.25%, and 0.40% respectively. Global trade tensions intensified over the month with no apparent signs of slowing down, investors seek lower volatility amidst global uncertainty, increased demand for high quality instruments such as investment grade bonds continued to contribute to the indexes in August. Despite compressed yields, we remain optimistic about the prospects of the fixed income markets.

After Trump announced new tariffs on another 300 billion goods from China on August 1, China has finally retaliated and announced an additional 5-10% retaliatory tariffs on $75bn of US goods, and will resume 25% tariffs on US automobiles on 15 December. Later, Trump retaliated, increasing tariffs by 5% to 15%-30%, some of which will be implemented during the Chinese National Day, which has a strong political implication. With the end of the trade war nowhere in sight, our view of the economic outlook towards the end of the year is relatively negative. As shown by the worsening economic indicators around the globe, global corporate earnings is expected to be further pressured in the 2 remaining quarters and the equity market will likely face greater volatility. Holding fixed income as the core investment can allow investors to navigate the investment environment in such turbulent times and limit the downside risk of the investment portfolio.

After the Fed rate cuts in July, many central banks across the globe followed. Notable ones include Reserve Bank of New Zealand, which cut 50 points, exceeding market expectations; India by 35 points to a 9 year low; Thailand by 25 points, the first cut in 4 years, and Philippines by 25 points which was the second cut in 2019. Looking forward, we expect both the Fed and the ECB to slash the rates again in September, as the economic indicators showed more weakness in the past month. Deriving from the interest rate futures, we are looking at possibly around 2 cuts from Fed before the end of the year, while the ECB is expected to follow suit and cut at least 0.2% in total further into negative territory in 2019. With central banks potentially entering an interest rate cut cycle, increasing bond exposure in the portfolio can also better capture the capital appreciation.

Another pushing factor for bond prices is the high demand from various investors, especially European and Japanese investors. German bunds and Japanese government bonds are very safe investments which are considered risk free, but as money flow increased, quantitative easing policies deployed, investors becoming more risk adverse, and various central banks cutting interest rates to negative levels, it drove bond yields down to unreasonable levels. German bunds are all negative yielding, while Japanese government bond are almost all in the negative territory apart from the 20, 30 and 40Y bonds. As investors would still want to capture positive return, most of them turned their attention to the currently higher yielding US$ denominated bonds which are still relatively safe. Thus, the global yields are falling due to increasing demand driving prices up, and the situation is likely going to continue in the mid-term as there are no alternatives for the relevant parties to invest in. This could also partially explain the rally in global aggregate bonds, investment grade bonds and T-bills, which rose around 2-3.6% over the month despite the falling equity markets.

We also note that the EM bonds and high yield bonds performed much poorer than their investment grade partners, which was mainly driven by concerns over general economy, EM liquidity and debt situation. As Argentina’s elections ended with an unexpected result, Argentine stocks and currency crashed on the surprise, Argentine debt yield skyrocketed as concerns over possible sovereign default mounted. Global investors were concerned if there would be any ripple effects in the EM investing universe as there has been unhealthy levels of debt in several EM economies. As the global macroeconomic environment worsens, the outlook for the relatively risky high yield bonds and EM bonds are less positive.

As the markets expects the global central banks to potentially enter a rate cut cycle amidst trade woes and economic slowdown, the global investment landscape will likely be symbolized by a higher volatility and downside risk in the equity market. Investors should consider adjusting their portfolio and include more high quality debt to limit volatility while still getting positive returns. The balanced portfolio may improve the risk-adjusted return.

Written by Harris Fraser Investment Research Team

Harris Fraser Investment Research Team embraces a top-down analytical approach to deliver a satisfying risk-adjusted return to meet the objectives of our clients. We start with macro-level research on an individual country, region, or sector before doing technical analysis like cross-market money-flow and trends to identify investment opportunities.

The MSCI Emerging Market Index dropped by 5.08% in August. We encourage investors to exercise more caution regarding the emerging markets towards the end of 2019, mainly due to risk factors mounting with limited visible positive developments. Two important factors for the emerging markets to perform, continued growth and a weaker dollar, might not hold true in the remaining portion of the year, but we will still need to keep an eye on any future developments. Our overall EM outlook for the year is neutral.

Building on Trump’s tweets at the beginning of August, the US-China trade conflict quickly escalated over the month, with both sides at greater odds with another. As we have yet to see the light at the end of the tunnel, the ongoing trade war is unlikely to come to an end before the end the year, the global economy is likely going to suffer with the increased trade tensions as global demand falls. This is reflected in various economic data, notably the global manufacturing PMI, with a significant number of large economies lying in the contraction zone. This is expected to disproportionally affect EM instead of DM since many of the countries in EM are export based economies, the drop off in global trade and world economy brings a lot of challenge to the relevant countries with the reduced demands and falling prices.

Another reason calling for more caution is the ‘hidden’ risk factors like political and regulatory risks that are inherent in EM. Take the recent Argentina incident as an example, both the Argentinean equity market and Peso dropped by huge margins of 35% and 25% respectively, after there were election surprises in the primary elections, where the incumbent Mauricio Macri was handedly defeated by the Peronist Alberto Fernandez. Investors were worried that if Fernandez got into power, the prior reforms implemented by Macri upon request of IMF could have been overturned, resulting in a potential country default. The panic reaction of the market towards the surprising result illustrated some of the hidden risks of investing in EM, where surprise factors could have lasting consequences, and the possible default of one EM country have the potential of spilling over to other EM economies with close ties. In Argentina, peer Latin American countries are potentially at risk of an economic downturn due to the situation in Argentina.

Another reason for caution is the relative strength of the US dollar. Historically, a weaker USD correlates with a stronger performance of EM investments, mainly through providing support via spillover effects when the market is ‘risk on’. Unfortunately for EM economies, the USD did not weaken at all over the past month. Instead, the DXY index rose 0.41%, despite Fed cutting rates in late July and interest rate futures implying further cuts in September and once more before the end of the year, USD stayed strong. While the weakening of the Euro and Pound provided support to the majority of the appreciation, as Europe is getting entangled in the Brexit matters, poor growth, and EU issues like Italy and Greece, global central banks including ones in EM economies are also following suit in rate cuts. Notable cuts include Reserve Bank of New Zealand which cut a hefty 0.50% and Reserve Bank of India which cut 0.35% to 5.4%, the lowest rate in 9 years. Global central banks following suit, freeing up liquidity in the financial system to stimulate their economy in the times of global uncertainty, is likely going to continue to be the norm as the trade war wages on, which relieves the downward pressure for the USD when the Fed cut rates in the future.

As mentioned in the past, we expect that EM growth in 2019 Q3 Q4 would be downward revised. For EM economic growth outlook, we are now less positive. Bear in mind that IMF did a downward revision of the global economic growth earlier which would likely drag the EM economy down due to its nature of export based economies. Despite the shaky fundamentals globally, we expect that the trade war beneficiaries like Vietnam and Taiwan should continue to benefit from the effects of the trade war as production lines move out of China. We revised our outlook of EM to neutral in the remaining portion of 2019, more caution is needed before investing in EM due to increased systematic risk.

Written by Harris Fraser Investment Research Team

Harris Fraser Investment Research Team embraces a top-down analytical approach to deliver a satisfying risk-adjusted return to meet the objectives of our clients. We start with macro-level research on an individual country, region, or sector before doing technical analysis like cross-market money-flow and trends to identify investment opportunities.