Summary

• It appears the spell of ultra-low volatility that had been cast over the global equity landscape during the past 12-18 months has been broken
• An escalation in trade tensions between the US and China is chief among culprits as the catalyst for the most recent broad-based equity decline
• While the argument for waxing and waning can be made, the risk of US-China tensions escalating further between two countries competing for global influence, economic and technological prowess and lasting longer than the majority of investors expect cannot be ruled out 

Market update

For market observers, it appears the spell of ultra-low volatility that had been cast over the global equity landscape during the past 12-18 months has been broken. An escalation in trade tensions between the US and China is the chief catalyst for the most recent broad-based equity decline. Given the levels of uncertainty which the proposed tariff threats have introduced, the key question from an investment perspective is whether the conflict will remain relatively contained or intensify into a genuine and sustained conflict.

First, the ‘good’ news. From a purely economic perspective, the overall impact of Trump’s proposed tariff directive is limited. Research by Bank of America Merrill Lynch and CLSA estimates a net impact, taking into account tariff levels imposed and price elasticity, of US$5-6 billon. This compares with total Chinese exports of US$2.3 trillion, and is inconsequential when measured against the size of the Chinese economy at US$12.3tr.  Likewise for India, with just 3% of India’s GDP coming from exports to the US ($77bn), and the trade surplus nearer to 1%, the impact is considered minimal.  Other Asian nations, excluding China (9%), represent 25% of India’s export market, with Europe reportedly importing 21% of goods, while the US receives 15% of India’s exported goods. 

Second, China’s response in terms of reciprocal tariffs has thus far been considered and measured. Third, despite the exchange of tariff threats, there is still a window of opportunity in which both parties can negotiate and seek a more agreeable outcome. Fourth, should upcoming US term mid-elections be a strong factor in President Trump’s decision to initiate the US trade war on China, a victory through extracting negotiated concessions as opposed to an all-out trade war will do no harm to his campaign and should be the preferred outcome.

Data regarding India’s macro environment displayed better than expected figures following the announcement of February’s more subdued inflation number of 4.4%, lower than forecast, coupled with a stronger industrial production number of 7.5%.  An improving macro, in step with a better micro environment, should provide renewed confidence to the investor community, despite the increased volatility experienced in global equity markets and the repercussions, particularly for emerging economies.

Fund activity

China

During periods of heightened market stress, elevated volatility and political tension, we do not want to be making short-term forecasts. Rather, we rely on the high level of rigour and discipline that underpins our quantitative decision making framework to allocate capital and manage risk in China. Our China market model seeks to provide timely buy and sell signals, on balance, through cycles. With the return of volatility and accompanying choppy markets, the model has been busier than usual.  We received a ‘bearish’ signal on 24 March, leading us to allocate a modest underweight allocation to China. As of now, the model favours domestically focused, cyclically geared China exposure.

India
We have retained an underweight in the market over the course of the month, awaiting a more opportune time to accumulate positions in areas where valuations are appearing more attractive once more.  Consumer discretionary stocks, including the Fund’s exposure to the two-wheeler and passenger vehicle markets are industries approaching attractive valuations once more.

Outlook

While the argument for waxing and waning can be made, the risk of US-China tensions escalating further between two countries competing for global supremacy and lasting longer than the majority of investors expect cannot be ruled out.

The US attitude towards China has turned decisively more confrontational in recent times, reflecting the view that Trump views China as a strategic adversary. Negotiations may stall or worse, collapse, leading to the imposition of various alternative economic and political tools to gain a perceived upper hand. These may include, but are not limited to, fines, the cancelling of existing free trade agreements, anti-trust investigations and the boycotting of products.

As always, we continue to pay close attention to our models to gauge underlying market conditions. In line with our mandate flexibility and tolerance, a protection strategy in the form of HSCEI (Hang Seng China Enterprises Index) put options and VIX (Volatility Index) call options has been administered. The objective is to dampen short-term volatility and/or the prospect of further downside returns in a manner which is cost-effective and can provide value to our clients. We are also holding c.8% cash which we anticipate deploying into stocks at more attractive levels.

For India, the continuation of the short-term bearish trading patterns is perhaps nearing an end following the conclusion of the financial year which typically demonstrates a propensity for profit taking by domestic investors.  The upcoming earnings season should continue the evolution of better statements from a broad cross-section of company management teams, which should produce a strong stock-picking environment over the summer months.  Prime Minister Modi will seek to address the concerns simmering around the upcoming state elections, and ensure the economy moves to a better footing ahead of the general election which is due to occur before May 2019.