Dubai
The risk of a global trade war remained high on the list of investor concerns last week, as the Trump administration moved ahead with the introduction of steel and aluminium tariffs. However, in contrast to earlier trade jitters in January, market sentiment now seems significantly more fragile, according to the Institute of International Finance (IIF), a global association of banks and financial institutions.
“Should protectionism escalate with tit-for-tat retaliation among trading partners, it could have a big impact on risk appetite. While potential “carve-out” exemptions from tariffs for specific countries or products indicate some softening in stance by the US, reports that broader measures against China may result from a probe on intellectual property practices suggest that protectionism could still intensify,” said Lucas Martin, Financial Economist, with the IIF.
According to IIF analysts, last week’s signing of the Comprehensive and Progressive Agreement for Trans-Pacific Partnership (the former CPTPP, minus the US) shows other nations still committed to trade integration, however, tensions aren’t likely to disappear any time soon.
“For investors, the prospect of trade wars has ominous implications on two fronts. If companies cannot pass through higher input costs to consumers, tariffs could negatively impact profit margins — which in the US are already facing potential headwinds from higher labour costs and rising interest expense, though tax cuts will be an offset,” said Sonja Gibbs, Senior Director of IIF, in a report.
Unless top-line revenue growth is sufficiently strong to compensate for lower profit margins, achieving the strong earnings growth expected by analysts may prove challenging. Even if the direct effects of tariffs on input costs are relatively modest, higher policy uncertainty may still dampen business confidence and investment.
Dovish relief
While trade war jitters have rattled investor confidence the European Central Bank’s (ECB) dovish stand has lent some support to risk appetite. Despite dropping its commitment to increase asset purchases if warranted by economic conditions, the overall meeting was interpreted as dovish due to the downward revision of inflation projections and President Mario Draghi’emphasis that the forward guidance adjustment did not represent a shift in policy stance.
A dovish ECB stance is likely to benefit emerging market assets, particularly fixed income. Indeed, European investors continue to show strong appetite for EM bonds, and inflows to Euro Area-listed EM bond funds have been substantially higher than those to US-listed funds.
“Despite February’s challenging market conditions, our latest analysis of portfolio allocation trends shows a relative preference for local currency EM bond allocations, consistent with the tightening of local currency bond spreads relative to US Treasuries observed last month (which has held up for many in early March). In contrast, US investors have shown a preference for EM equities and inflows to US-listed EM equity funds have been higher than for their Euro area listed peers,” said Martin.
Analysts say high-yield bonds as an asset class has weathered the recent market rather well although they remain concerned about high and rising debt levels. But losses to date in high-yield bond markets have been relatively modest despite significant outflows. Notably, emerging market high-yield bonds — where issuance reached a record high of $140bn in 2017 — have witnessed a significantly smaller widening of spreads compared to mature market high-yield bonds. However, credit quality as proxies by credit ratings has begun to deteriorate at a faster pace for EM HY issuers, in contrast to the more balanced outlook in early 2017.
Given the high share of EM bonds denominated in hard currency (primarily US dollars), the direction of the dollar remains a significant risk factor. While US financial conditions have tightened modestly, some regulatory easing in the US may be forthcoming given a Congressional plan to lower the asset threshold for banks to be considered systemically important. China has also taken steps recently to lower provisioning requirements for non-performing loans (although from relatively high levels by international standards).
