Year-to-date (ytd) Emerging Markets (EM) is the worst performing region with Emerging Market Asia being down 6% and Latin America (LatAm) down 9%. We see a 60% chance that the newly announced tariffs on $200bn Chinese products take effect in September. A trade war is lose-lose for both sides. Historically, U.S. exports and imports rise or decline together. Hence, both sides should want to return to the negotiating table. But because China is at greater risk to tariffs owing to its larger U.S. exports and that tariffs could aggravate the risks of China’s deliberate slowing of investment spending to defend asset values underlying loans, we think it is likely that China will reoffer a deal that could avert these tariffs.
By including the additional proposed tariffs in the existing 301 process, the additional tariffs on $200bn goods will have a relatively short time frame to be imposed if that’s what the administration chooses to do. The Trump administration states that it doesn’t want to raise tariffs, but wants other countries to lower theirs. The sincerity of this stance is debatable, but it would help if other countries clearly and loudly offered to lower their tariffs as soon as possible to stop new U.S. tariffs. Retaliations and threats of such empower protectionists here and elsewhere, but offers to drop tariffs by other countries could open the door to a win-win solution. We realize this isn’t easily done quickly, especially by the EU, and threatens preferable multilateral dealings by introducing bilateral deals. But without quick deals or offers of such to lower tariffs, the higher-tariffs outcome is gaining chances.
If the 10% on $200bn Chinese goods is implemented and retaliation and further escalation occurs, downside could be 5% for EM Asia, but similar for Europe and the S&P 500 (S&P). This could be less if China quickly offers conciliatory compromises. If negotiations stop or swiftly rescind the tariffs, then EM Asia could rally near 20%, 10% for Europe and 5% for the S&P. Our 12-month targets across global equity indices include some trade risk, but a 5% cut to our June 2019 target for EM Asia and 3-5% cuts to Europe and the S&P are feasible upon further escalation. EM Asia is currently trading at 10% below our 12-month target, so limited 12-month downside with tariffs. We see near-term negative trade headlines to pressure global equities and change our “Next 5%+ Price Move” for the S&P from “Balanced Risk” to “Down.” On a probable basis, EM Asia offers the best upside over the next 12 months and we expect global equities to appreciate over the coming year as tariffs are unlikely to cause a recession or stop S&P earnings-per-share (EPS) or EM Asia EPS growth. We cut equity allocation by 2% to 63% and raise fixed income to 32%.
We keep a close watch on earnings trends across regions. There are some down revisions to EM Asia 2018E EPS consensus since June as trade tensions escalate. But these cuts are not due to weak revenue or margin outlook, they are more currency-related on Chinese-yuan (CNY) depreciation. S&P is the only region with upward earnings revisions ytd. Europe and EM saw their 2018E EPS cut, and Japan is flattish excluding its tax-cut benefit. Our CIO forecast for next-twelve-months (NTM) EPS growth: S&P up 12.9% year-over-year (y/y) and EM Asia up 11.5% y/y. These are the strongest regions, EM Asia would be the strongest excluding the S&P’s tax-cut benefit.
Another reason we think EM Asia has better upside is its even bigger valuation gap to the U.S. after its selloff on trade threats. Currently, the S&P is trading at a 10% premium to its average trailing and forward Price-to-Earnings ratios (PEs) since 2000; Europe is trading in line with its historic average; EM Asia is trading at 5% discount while offering the best corporate-profit growth among all. Low interest rates globally are supportive of higher-than-normal PEs at all regions. We think the EM Asia equity market is discounting more of the trade tension than the other regions. Our base-case view is still that even with some further trade-conflict escalation, including some auto tariffs, that U.S. and global gross domestic product (GDP) will be decent, so we remain constructive on global equity markets.
CNY depreciation of 7% since its April peak is likely to stick and there might be a little further depreciation from here, but it’s unlikely to be more than that as China would intervene. China could pursue other methods to cushion slowing exports like cutting corporate taxes and easing credit availability. Other countries in EM Asia, like India, have healthy economic growth and investment spending, which should help bolster the region’s overall economy. Excluding China, other countries are 63% of equity market cap of Asia ex Japan. Chinese equities have become more growth-sector-oriented with 40% of the Chinese equity-market cap being Tech and 56% Tech, Consumer and Health Care.