24 March 2019

We are starting to see real signs appearing that the US stock market's bounce from its December lows is looking exhausted and share prices are looking poised for a notable correction from here. Having reversed course and turned bullish on Japanese cyclicals at the start of January, sensing that geopolitical climate regarding a US/China trade deal is turning more favourable and the Fed was turning less hawkish, we now think there are more ominous signs appearing again which could derail this quarter's big bounce and could send shares into a tailspin once again. 

One big red flag is the inversion of the US yield curve which looks to have finally appeared following big moves down by longer term treasury bond yields. This seems to suggest that the market is now anticipating more than just halting of the Fed's normalisation of its monetary policy and shrinkage of its balance sheet and is demanding a more accommodative stance which seems unlikely in the short term. 

With banking stocks under pressure as the inversion will eat into their margins and inevitably force them to adopt a more cautious lending stance, the US and other central banks look to be facing a very difficult situation where they might have to kick the can further down the road by resorting back to quantitative easing in trying to calm investors' fears. In Japan, BOJ's room to manoeuvre looks even more limited than elsewhere as longer term bond yields have already moved back into negative territory this year, adding more pressure on banks to curtail lending while the very deleveraged Corporate Japan is unlikely to see any notable benefits from lower rates. 

These negative developments seem to have been reinforced by the sudden strengthening of the Japanese currency late last week, underlining the risk-off mode that the market looks to be entering again. Although we have have been hopeful that the likely trade deal between US and China and a more dovish Fed will keep cyclical stocks on their recent uptrend, we now believe these developments have now been over-run by more immediate economic concerns that would warrant a notable change in strategy as we see short term selling pressure overshadow any hopes for second half recovery which had kept semiconductor and automation names on the rebound trail until now.

The geopolitical back drop has also turned very murky with the US Special Counsel's report of a possible Russian interference in the last US presidential election finally submitted to the US Attorney General. We believe the political wrangling in forcing to unveil the details of findings to the US Congress and the public has only begun. This could distract the White House from immediate concerns about putting the trade dispute with China to rest. 

Moreover, with China demanding US policy makers to remove the existing tariffs on its exports as a show of good will and Mr.Trump stating that existing tariffs will stay on for a substantial period of time until they see concrete signs emerging of China complying with US demands, we might see trade talks dragging on longer than we had hoped, putting further pressure on stock prices. With corporate earnings looking unlikely to provide much support in the shorter term, we look to be entering back into a severe correction phase which could see share prices coming back to test their December 2018 lows. We thus urge reversing course and taking profits in cyclicals and adopting a much more defensive stance for the time being.