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Staying positive and adding China exposure

Steven Wieting

By Steven Wieting

Chief Investment Strategist and Chief Economist

January 31, 2020Posted InEquities, Commodities, Fixed Income and Investment Strategy

The Citi Private Bank Global Investment Committee left our overall asset allocation unchanged at our 29 January meeting, while shifting equity weightings between regions.  We remain 3% overweight Global Equity, and 4% underweight Global Fixed Income, with Gold 1.5% overweight as a tactical risk hedge.  Cash remains 0.5% underweight.

We added to our overweight in Greater China markets by reducing our overweight in other Asia-Pacific markets and in US.   Regional equity markets impacted by the Coronavirus that began in the Chinese city of Wuhan have slumped quickly, diverging unusually from US markets. The reasons for this could prove temporary, as during the 2003 SARS crisis. They may remain under pressure as first quarter economic activity in China weakens. However, regional markets seem likely to recover fully within our 12-18 month tactical allocation window. Meanwhile, US asset markets appear to have benefited from ‘flight to quality’ inflows, benefiting our overweights in both US equities and fixed income.

China and Hong Kong will suffer a severe blow to services activity as a result of precautionary travel bans and related measures aimed at containing the Coronavirus (see our bulletin for discussion).  This may temporarily impact the global economy through supply chain disruptions.  However, as with other natural disasters, the Coronavirus largely does not represent a permanent loss of output.  While China’s markets remain closed for an extended holiday, proxies for broad Chinese equity markets traded in the US have fallen more than 12% within the past two weeks.  Hong Kong equities have fallen slightly more. During the SARS crisis of 2003 - which unfolded beneath a greater shroud of secrecy- Hong Kong’s equity market declined 18% before rising 48% in the following year.

To date, China’s policy response to economic challenges led by US tariffs has been quite measured. We would now expect more decisive stimulus.  At the worst of the SARS episode in 2Q 2003, China’s growth slowed to about 3.5%, before rebounding to a 15.7% annualized rate in 3Q 2003. However, the Chinese economy today is far more developed and faces wider growth challenges. We would therefore not expect similar GDP growth rates to 2003, although the pattern provides a useful precedent. 

Meanwhile, US equity markets remain only 1.5% below their record highs. More importantly, they have outperformed global equities by 10% in the last twelve months. Notably, the valuation gap between US and non-US markets has reached record levels by several measures. 

Large-cap US equities remain a small overweight even after our reduction, and US equities remain by far our largest single asset holding.  The US equity market benefits from strong sectoral diversification within a single geography and our outlook for US economic growth remains constructive.  However, the very strong performance of US equities over the past twelve months appears to price in a full rebound in industrial activity and international trade. By contrast, non-US markets linked to the same activities have lagged. With these changes, Asia emerging market equities move from a 1.2% to a 1.7% tactical overweight, while US large-cap equities are 0.2% overweight. 

Prior to the drop in Asian markets, global equities had rallied 17% since August, with the US outperforming.  Over the same period, government bond yields fell and credit spreads simultaneously tightened. We are concerned that the US Federal Reserve’s powerful actions to smooth US money markets during the turn-of the-year holiday period provided a boost to financial assets that will not be repeated. The very strong performance of both rates and credit markets has further limited the appeal of fixed income, but also likely benefited certain equities indirectly.

Both higher-yielding, defensive equities and growth stocks in the US market have outperformed dividend growth stocks in the past month.  We see this strong market performance waning to the benefit of higher quality dividend growers (see Stocks for Bond People) within a more volatile market overall. 

US politics could be another source of market volatility, particularly for US equities and fixed income. However, this is not our base-case view. The US-led trade war widening to Europe this year is also a risk, albeit not in our view the likeliest outcome. From present levels, we would expect US total returns in equities to be about 5% over the coming twelve months. Non-US equities could rise 6 to 8%, with dislocated markets in Asia rising more. These tactical return assumptions assume the usual wide trading ranges. Our overweight allocations to US Treasuries, investment grade corporates, and gold provide risk mitigation in the event of more negative economic outcomes than we expect. A stronger US dollar remains a broad portfolio risk in the event that safe-haven inflows continue to boost US assets for longer than we expect.