(05 AUGUST 2019) DAILY MARKET BRIEF 2：Economy Dissecting the impact of renewed trade tensions

Potential non-tariff measures include a managed depreciation of the CNY to mitigate the trade impact from higher tariffs, penalizing select US companies operating in China, or imposing export restrictions on rare earth metals.

Our view has been that China will increase its monetary and fiscal support in 2H to cushion the existing growth slowdown, and believe Beijing has room to increase support if needed. Potential measures include 100–200bps of general cuts to the reserve requirement ratio (RRR), reduced open market operations and the application of lending facilities to keep liquidity sufficient. Beijing will also likely guide lower general funding costs, especially for SMEs and private companies. On the fiscal side, support could come from greater infrastructure investments.

The overall tariff hit on economic growth at this point remains unclear. However, we reckon that Chinese GDP growth in the next 12 months could fall by 0.25–0.5ppt as a result. This would push the country's GDP growth rate below 6% into 2020.

On a more regional level, President Trump's latest move puts our guidance for a recovery in trade and industrial activity towards the end of the year at risk. It might also speed up central banks' easing efforts in the region, as they seek to mitigate the persistent external growth headwinds.

APAC currencies have come under broad pressure versus the USD on the back of this escalation. In the near term, APAC currencies are likely to struggle against the USD given the latest revival of in trade tensions. However, much depends on how China reacts to the latest tariff threat from the US.

In a positive scenario where the latest tariff threat serves to accelerate progress on US-China trade talks, the downside risk for APAC currencies should be mitigated. In the worst-case scenario of a complete breakdown of US-China trade talks, coupled with a further escalation on the US side (25% tariffs on all Chinese goods), APAC currencies (except the JPY) would come under broad selling pressure, with the USDCNY exchange rate rising to a 7.0–7.3 range.

Over the next 12 months, we estimate the new tariff would lower Asian earnings by 5%. This would reduce profits by 1.5% for 2019 and by around 3.5% for 2020; our prior forecasts were 6.3% earnings growth for 2019 and 8% for 2020.

If all US tariffs on Chinese goods are raised to 25%, we believe earnings would fall by 11% (5% by the 10% tariff, another 6% by the raised amount), which could wipe out all earnings growth in 2020.

If the 10% tariff remains in place, we see mid-single-digit downside to current valuations for Asian equities. If the tariffs are all raised to 25%, we see mid-teen downside.

Asian markets will likely stay volatile in the near term until progress is made on trade negotiations. We remain neutral on Asian ex-Japan equities, and continue to expect mid-single-digit share price upside so long as tensions do not escalate further and the worst-case scenario does not materialize.

We believe the following strategies should help investors navigate Asian equities:

1. Stocks with high dividend yields: the risk-reward looks attractive for Asian stocks with high dividend yields, as inflation and 10-year bond yields are low in the region

2. Asian large caps: We believe Asian blue chips will be resilient during the current uncertainty given their robust business models and superior return on equity

3. Stocks with high domestic exposure: We believe stocks with high domestic exposure should fare well given their limited exposure to the additional tariffs. These include Chinese internet companies as well as select regional stocks in insurance, consumer and telecom sectors. Malaysia, our second overweight next to China (where the direct revenue exposure of listed companies to North America is a mere 2%), should also relatively benefit given its high exposure to stocks with domestic growth prospects. 
   

Asian investment grade bonds (IG) have widened by 5–10bps on 2 August (at the time of writing), while high yield (HY) has dropped by 0.5–1pts. But when considering the US Treasury rally, the impact of the tariff-escalation on returns has been minimal.

High yield spreads could move 20–30bps wider should the negative headlines continue in the coming weeks, in our view. However, we see a low likelihood of a more significant sell-off because of our view that the Chinese government will ramp up easing efforts. Also, issuers with direct exposure to trade in the HY index is less than 3%. As such, we maintain our 2–3% HY return expectation for 2H19. In our Asia tactical asset allocation, we remain overweight Asia HY versus high grade bonds.

BY UBs