09 June 2019

As has been the case for much of last year and thus far in 2019, external issues dominate what happens to Japan's stock market, leaving us mainly focused on US trade and monetary policies which are the main drivers in sentiment. With Japan's trade with China being 60% bigger than with the US, it is not surprising to see Japanese stocks seeing the biggest declines among developed markets this year. 

After having raised the threats of an all out trade conflict (with almost everyone), we sense that we are entering a period again when Mr Trump could start to soften his tone as he has done most recently with Mexico, declaring that 5% tariffs on its exports to the US which was only announced the previous week will be suspended indefinitely. With G20 summit scheduled for 28th of June, hopes are rising that high level trade talks will resume once more and some sort of meeting between the heads of China and the US will be announced for that date.

We think a potential to offer the Chinese to remove the recently increased tariffs if a trade agreement is reached would go a long way in avoiding an escalation which has all the potential to dangerously spill over to other domains with Taiwan having become another key sensitive issue following reports that the US is looking to sell over $2bn of arms to help it defend its borders. Thus far, China's response has been very measured, having yet to follow through on its export ban of rare earth metals and has yet to release the list of Unreliable Entities that could surely hit firms doing business.

As we have seen many times this year, market conditions can flip on just a tweet. This is a key reason why we have generally avoided recommending shorting tech names more recently, despite clear deterioration in their earnings outlook as we foresee a decent bounce in this segment if the US president follows his Art of Deal playbook and backs down from some of his highly disruptive policies which have left business plans virtually frozen.

So the markets remain fairly path driven led mainly by geopolitics, not to mention, the fact that they have become increasingly reliant on the Fed to ease monetary policy to help absorb the trade conflict shocks. Indeed, the recently weaker US economic data has been celebrated as nearly 75bps cut in the fund rate has now been priced in by the US Treasury market. With US employment growth and industrial output easing and US GDP growth looking to more than halve from last year to just over 1%, all the pressure is now on the US central bank to cut rates, possibly as soon as July but most certainly by September.

However, we fear that much of the damage to corporate confidence levels has already been done. So although suspending tariffs on Mexico might provide some relief to plant operators in the country, it is unlikely to unfreeze capex plans to expand production bases there. This is especially so as trade policies are now being weaponised to achieve other political objectives, namely immigration flows in the case of Mexico.

As far as China is concerned, the air of distrust from both sides have risen to such levels that any sort of trade agreement between the two sides is now likely to be received much more cautiously by market participants. With US looking to provide weapons to Taiwan and is said to be refusing visas to Chinese students, not to mention, banning sales of components to Huawei, it is clear that US policy makers are unlikely to reverse their hawkish policies to the extent that help normalise economic relations.

We, thus, view any easing of tensions which the market could rally on from here as likely to prove temporary, potentially providing big shorting opportunities in the tech space later this summer. We also think chances for a second half earnings recovery scenario which the market participants were very much hoping for up until end of April, have all but vanished given the uncertainties and disruptions Trump's trade policies have created from the start of May. We expect guidance for Q3 earnings now to be weaker from Q2 levels, postponing any hopes for a meaningful bottoming to H1 of next year.