Don’t get too comfortable

US-China trade deal and Brexit are far from settled, yet many investors are still bullish, writes Piyasak Manason

For investors, October has been a sunny month. Stocks around the world have been on the rise. The US dollar has fallen by more than 2% against other major currencies. Most importantly, the yield of the three-month US Treasury bill has been lower than that of the 10-year bill. In other words, the inverted yield curve, seen as a reliable warning sign of a future recession, has become normal again. Yet investors continue to look on the bright side.

What is causing this risk-on sentiment? And will the good times last? The answer to the first question lies in three positive developments that affect the economy.

The first is there is a high possibility of a preliminary trade deal between the US and China. A “substantial phase one” agreement, in which Washington does not raise import duties further, in exchange for a Chinese pledge to buy more US agricultural products, is expected to be signed by the two countries’ leaders at the Apec meeting in November.

The second is the UK will not crash out of the EU today without an agreement, as many had feared. Mind you, it isn’t leaving with an agreement either, but the EU has now given British legislators until Jan 31 to think about it. In the interim, there will be an election on Dec 12.

The last positive development is the US Federal Reserve has moved to solve liquidity shortage problems that emerged in September, when the effective Fed funds rate rose to 10% at one point, against the official rate of 1.75% to 2.00%. The central bank is making short-term purchases of $60 billion in bonds over a six-month period, and the New York Fed has been buying $7.5 billion in short-term bonds every day to pump liquidity into the system.

SUSTAINABILITY AT ISSUE

Even though these developments have made investors feel more comfortable, SCB Securities believes they are not enough to ensure a sustainable recovery. We offer three reasons.

First, the good news about the trade war is in fact just a handshake between President Trump and Chinese Vice-Premier Liu He; there is no agreement on paper yet. In addition, there has been no clear agreement on important and sensitive issues such as forced technology transfer, intellectual property and Chinese government support for state enterprises.

The second is Brexit is still very much up in the air. Opinion polls suggest Prime Minister Boris Johnson’s Conservatives should win the Dec 12 election, but whether they will have enough MPs to push through Brexit by Jan 31 is anyone’s guess.

Even if a new deal is agreed on by all sides, there will effectively be two sets of rules: one for Northern Ireland and another for the rest of the UK. In the absence of a hard border with EU member Ireland, customs and tax issues will have to be sorted out somewhere else, leading to delays as well as a financial burden on both British and EU citizens, affecting both economies.

Third, the Fed has stressed that its liquidity injection is only temporary and not quantitative easing. Hence, it will not have a significant positive impact on the US economy.

While the liquidity shortage in the US financial market involves both structural and seasonal factors, it is clearly not a good sign. Financial managers may see it as a warning sign of recession and may increase their holdings of liquid assets, which will subsequently lead to scarcer liquidity.

WEAK INDICATORS

These three scenarios are not a good sign for the global economy in the long run. Combined with other indicators — such as weaker US retail sales, non-farm payrolls and manufacturing output, as well as the lowest Chinese GDP growth in 27 years — and we can see the global economy visibly declining.

The IMF has confirmed this picture by revising its global growth projection down, from 3.2% to 3.0% this year, and from 3.5% to 3.4% next year.

We think the IMF is being too optimistic. We believe the global economy next year is highly likely to grow by less than 3.4% because of two main risks. First, euro-zone expansion will probably be below the 1.4% expected by the IMF as a result of the fragile German economy and Berlin’s reluctance to use fiscal stimulus. Second, world trade may expand by less than 3.2% given the impact the trade war has had so far on global supply chains.

As the overall global slowdown appears to be a near-term reality, any investment decision should be made with caution. We therefore recommend diversifying investment into assets with stable and reliable returns, such as mutual funds that invest in stocks of world-class consumer products, as well as real estate investment trusts, infrastructure funds, debentures, companies with good financial status, dividend stocks, and gold to hedge risk.

After all, what you see may not be what you get.

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While the liquidity shortage in the US financial market involves both structural and seasonal factors, it is clearly not a good sign.