Markets have rallied on expectations that President Trump would advance his fiscal stimulus agenda. Tax cuts, deregulation and infrastructure spending promises lifted sentiment and confidence levels higher despite negative rhetoric over trade and tougher immigration policies. The euphoria led to an initial "benefit of the doubt" rally where economic gains from expansionary fiscal policies appear to offset the headwinds from a protectionist agenda. The early optimism was then replaced by reflation catalysts which moved equities higher and spurred greater risk appetite across global equities.
The reflation trade extended as economic data seemed to underpin growth momentum. Central banks echoed this sense of confidence, after the Federal Reserve hiked interest rates in March for the third time since the global financial crisis. In addition, the European Central Bank suggested that the deflation risk was fading. However, this all raises the question of whether the risk now is one of misplaced optimism. Core inflation, a reading that excludes volatile energy and food prices, remains soft in developed economies. A sudden shock in oil price could well alter monetary policy.
If confidence and economic momentum were to wane, then a reflation trade is likely to follow as markets begin to ponder whether the transition from fiscal promise to actual policy is achievable. This is evident as President Trump prioritized and then had to pull back from a controversial healthcare bill in order to fund tax reforms, raising speculation that the White House will struggle with other policies despite a Republican controlled Congress. Given the upcoming 2018 mid-term election season, the window to push forward Trump’s pro-growth agenda becomes more difficult.
As sentiment begins to question the reflation trade, Asian markets appear likely to become more attractive. While Asian equities have benefited along with global markets from renewed risk appetite this year, the catalysts that lifted them were different. Although optimism in the private investment cycle and global economy was a positive, Asian equities also benefited from encouraging data coming from China and India, suggesting that the region’s two largest economies would fare well if protectionism were to surface due to larger domestic driven markets. Lower vulnerability and ebbing deflation pressure partially explain MSCI China’s 13.2% first quarter returns, while the fading impact from demonetization lifted MSCI India 11.7% over the same period. China and India returns come amid the MSCI Asia Ex-Japan Index 13.2% return so far in 2017.
It is not only in China and India that year to date performance suggests that investors are looking beyond specific domestic factors and potential trade barriers; the same applies in the North Asian markets of Korea and Taiwan where there is more leverage to the global trade cycle. The MSCI Korea return of 8.0% over the first three months of the year comes amid bellicose cross-border tensions from North Korea, subsequent Chinese tourist travel restrictions due to the deployment of THAAD, and the impeachment of President Park. Despite the current power vacuum and Presidential elections due in May, investors have taken the view that regardless of the new policymakers, reform of corporate governance will be a political priority in South Korea.
In the same way as US equities, Asian markets could be susceptible to a correction were politicians to disappoint by failing to deliver on their promises.
Given the year to date rally, concerns have already surfaced in India, where optimism following Prime Minister Modi’s surprise landslide victory of his Bharatiya Janata Party (BJP) in the large state of Uttar Pradesh has faded following the appointment of Yogi Adityanath, a Hindu Nationalist. However, investors appear confident that the BJP is well position to sweep the next general election in 2019, and foreign inflows and investments have supported a 4.5% rise in the Indian rupee 4.5% year to date. While it is possible to argue that investors are also providing Indian equities with a benefit of the doubt trade, the economic readings still remain encouraging, particularly after India’s GDP expanded 7.0% in 3Q fiscal year 2017. Such a level of growth limits concerns over the impact of demonetization from late last year.
Asia’s commitment to promote liberal multilateral trade translates into an improved economic outlook and growth in outbound investments. China has led engagement such as the Regional Comprehensive Economic Partnership (RCEP) of 16 nations and the One Belt One Road (OBOR) initiative comes as a time when the US administration is gravitating towards more bilateral arrangements. Following the healthcare and budget proposal debacles from the Trump administration, extending the market rally driven by higher growth expectations becomes more challenging. It would be naïve to argue that trade protectionism is completely removed. If US growth fades, then the Trump administration could still advocate a border adjustment tax, arguing that reducing the deficit would boost the economy. Ironically, this would do the precise opposite, and benefit Asian exporters at the expense of US manufacturers.
Looking to the month ahead, geopolitical risks across the US and Europe will garner the most market attention. Upcoming US mid-term elections have already galvanized voters to pressure elected officials to abandon some Trump policies, while Brexit negotiations and elections in France, Italy, and Germany could become a source of market angst.
The silver lining in the context of a divided US Congress and lethargic Brexit negotiations could just be the influence of the Dutch election when Prime Minister Mark Rutter defeated far-right politician Geert Wilders. Though small relative to the European political landscape, the election in the Netherlands could be seen as emblematic of fading populist momentum given the inability of nationalists to produce meaningful alternatives or solutions. A focus on economic growth and a pickup in investment are palatable solutions to ease anti-globalization sentiment, where policy will likely gravitate.
Asian markets would initially follow any US correction but a decoupling seems more probable given that the catalysts for the Asian rally in 2017 were different, and they should therefore continue to perform well for the remainder of the year. Ongoing supply side reforms in China and rising intra-regional trade should bode positively, helping economic outlook which feeds into a more conducive political environment. If markets were to correct due to a pullback in the reflation trade or as a result of a watered down tax reform compromise from the Trump administration, this would be an ideal opportunity to build a position in Asian equities, as investors focus on stability in this growing region.
Christopher Chu
Assistant Fund Manager - Asia