2017 global market outlook dusk before dawn for asia pacific ex japan equities 1840522016

As 2016 draws to a close, let’s us take stock of our global market outlook for this year (published in late December 2015) where we expect the U.S. equities to outperform the rest of world with a positive return Indeed, the U.S. broad based benchmark S&P 500 has managed to record a year to date gain of 12.5% based on the closing level of 21 December 2016 and it is the only geographical market to print a new record high (2277 on 13 December 2016, 2.5% away from our 2016 expected upside target of 2335).

2016 will mark the seventh year of the current major bull cycle for U.S. equities since the “famous” March 2009 low of 666 printed on the S&P 500. Now, how will 2017 unfold? Can the on-going strength seen in U.S. equities and an improving U.S. economic landscape trigger a positive feedback loop into Asia Pacific ex Japan equities after a lacklustre performance in 2016? We have doubts about this proposition and see the risk of a 25% to 30% correction first before a potential recovery.

Key risk factors

• Global liquidity tightening led by U.S. Since the Great Recession of 2008/09, global equities have been supported by ultra- loose monetary policies via quantitative easing programmes from the major central banks (Fed, ECB, BOE & BOJ) for more than five years which is the longest duration since the 1929 Great Depression. The U.S. Fed has now taken the lead in normalising policy interest rates (in the last FOCM held on 14 December 2016, Fed officials have increased the projected Fed Fund rate hikes for 2017 from two to three). In addition, central bank officials have stressed in major forums that loose monetary policies have now reached the stage of diminishing returns in boasting economic growth and the baton now should be hand over to fiscal policies. Given the rise of populism (Brexit, the recent Italian referendum, Trumponomics), it is likely that expansionary fiscal policies will gain momentum in 2017 which will cause future interest rates to be higher via a widening of government budget deficits.  Technically, the benchmark sovereign U.S. 10-year yield had formed a base in July 2016 and it is heading towards the resistance of a long-term descending channel in place since November 1994 now at 2.99%. A break above 2.99% is likely to trigger a further spike towards 4% in the first step.
• The on-going U.S. dollar rally (with reference from the U.S. Dollar Index) is expected to continue after a potential pull-back/consolidation towards the 100.00/98.85 level from a technical analysis perspective. Further potential upside target is set at 109.19/110.68. Fundamentally, a strong U.S. dollar will not be in favour for Asia Pacific (ex Japan) equities because private non-financial sectors’ (non-bank corporations & households) debt levels denominated in USD as a percentage of GDP have risen beyond pre-2009 levels with Hong Kong, China,  South Korea and Singapore leading the pace in terms of magnitude (see chart 1). Coupled with a tightening liquidity condition, profit margins of firms operating in Asia Pacific region (ex Japan) is likely to face downside pressure as cost of borrowing rises.
• Repricing of risk from a currency war and a potential risk-off event triggered by China. Stock markets across the Asian Pacific region and the rest of the developed markets in U.S. and Europe had experienced a negative shock wave after China surprised with second devaluation of its Yuan against the USD in early 2016. Right now, both the onshore (USD/CNY) and offshore (USD/CNH) had already surpassed the January 2016 high level and continued to climb upwards. This recent Yuan weakness have been further exuberated by capital outflows which have grown by more than US$900 billion in 2016 based on estimations from Natixis SA, a French investment bank despite new restrictions enacted to stem the outflow such as prohibitions on using credit cards to purchase for insurance products in Hong Kong. From a technical analysis perspective, the offshore (USD/CNH) has the potential to rally further towards the 7.18 level after a pause (see chart 2). It seems that recent attempts by China regulators have been futile and the main reason for the regulators to reduce magnitude of the capital outflows is to prevent a liquidity squeeze in the local banking system. In addition, with delinquency rates of close to 30% seen in China’s banks, a further tightening liquidity condition is not a good omen for these banks given the current heavy burden of such bad loans. We think that market participants have not fully priced in such risks given the current euphoric state of optimism from “Trumponomics” and if USD/CNH continues to ascend as expected and capital outflows not contain, a negative shock wave from China cannot be ruled out in 2017.
• Technically, the MSCI All Country Asia Ex Japan ETF (AAXJ) has started to exhibit bearish elements (see chart 3). As long as the 61.63 long-term key pivot resistance is not surpassed, the ETF may see a further downside movement towards 47.60 before 43.43 with a maximum limit set at the 40.60/39.50 support zone (the lower boundary of the long-term expanding wedge/range configuration in place since November 2010).
• Limited upside is expected for Australia stock market. We expect the boost from the recent upward price movement of base metals such as zine and copper driven by the infrastructure spending component of “Trumponomics” and strength in Financials to be offset by the risk of a slowdown in China (see risks highlighted above) as Australia is now far more exposed to the economic fortunes of China rather than U.S. Therefore, we expect the benchmark ASX 200 to trade in a range bound configuration between 6000 and 5148 (see chart 4).

Chart 1 – Borrowing spree as U.S. dollar credit continues to grow in Asia Pacific

Source: Bank for International Settlements (click to enlarge chart)

Chart 2 – Further upside potential in USD/CNH

Source: eSignal (click to enlarge chart)

Chart 3 – Not looking good for Asia Ex Japan equities

Source: eSignal (click to enlarge chart)

Chart 4 – Range bound for ASX 200

Source: eSignal (click to enlarge chart)

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