Monthly Report (2016.6.17)

Market Update

As expected, the HSI experienced a stronger rebound in late of May and peaked at around 21000 level early this month. However, the rebound was not due to our expected reason that the U.S. dollar would start to turn weakness, but the hope on the inclusion of China A-share into the MSCI index and the Shenzhen-HK stock connect policy might soon to announce.

Since early of June, global markets are all focused on the potential threat of the exit of Britain from the European Union (EU). The fear triggered global investors to switch into the risk-off mode, with global stock markets were coming under severe selling pressure, including China/HK, while massive liquidity flows into the safe-haven assets, such as global government bonds and gold.

The reason why investors are suddenly so worry about a British exit from the EU is mainly because the latest polls in the U.K. continue to show increasing support for Brexit, with the one done on June 8 showing the “Leave” camp holds a 10% lead over the “Stay” camp, the biggest lead since the start of the polling. As a result, investors start to price-in the Brexit risk as it would represent a bigger risk to the entire Euro system.

We believe the Brexit issue will continue to be the critical factor for the global equities, bonds, and currency markets in the near term. There is now less than a week until the British will vote on whether to stay in the EU. Even though the people in general are now starting to believe the “Leave” camp is on the upper position to win, we expect the British will vote to “Stay” is still the most likely outcome. Why?

Firstly, if we look into the polls more deeply, there are differences or patterns between the results which were done by the Online or Phone surveys. In the past six months, most of the polls done by the online surveys were favored the choice of “Leave” while phone surveys were favored to “Stay” (We don’t know why). Since the beginning of June, most of the polls are indeed done by the online surveys (9 out of 13). And the one which shocked the global markets on June 8 with the biggest lead of 10% over “Stay” camp was also done by the online surveys. We believe this is one of the reasons why we hear about the latest news that we see increasing support for Brexit in the past 1-2 weeks. If we look at one of the latest surveys conducted by the Number Cruncher Politics a few days ago (June 13) which gave equal weighting to online and telephone polls, the result was 45.9% “Stay” and 45.5% “Leave”, with 8.6% undecided.

Secondly, there is little doubt that the British’s decision is now shifting more to the direction of a Brexit according to most of the recent polls. However, as explained above, we believe the difference between two camps are actually very small. As such, we believe the undecided voters are the key to determine whether Britain will leave or remain. If we look into the British history, in five out of six referendums held in Britain since 1975, support for maintaining existing conditions or “No Change” option almost always increases in the days before the referendum. We believe the indirect meaning is that most of the undecided voters are belongs to the “Stay” camp. The reason for this to happen probably because the undecided voters are likely to vote for this option as it seems less risky. Actually, the pattern in a Scotland independence referendum in 2014 also share similar pattern, with gradual increase in support for independence or “Leave” until the very end of the voting days, when more voters shift towards the “Stay” option. As such, with the current 8%-10% voters are in the undecided group, we expect the final result is the “Stay” camp will win, but probably just lead to a few percentages over the “Leave” camp.

If we were right, we expect the HSI probably will find a short-term bottom at around 19700 before June 23 and we will see a stronger technical rebound to around 21700 in coming weeks after the judgment day.

In the long-term perspective, we have slightly revised down the possibility that we can find a secular bottom in between 2Q16 to 3Q16 period last month given the latest global economic indicators continue to show a global recession scenario is gradually picking up. Now, there is not much change from our previous forecast and we continue to see a 50/50 chance that we will either fall into a global recession case or we will see a lukewarm recovery in the coming 6-12 months. The reasons that the recession risk is still picking up gradually because:

 A sharp deterioration in the US job market in May and the declines in payrolls are in broad based with declining in temporary employment as well.

 US Labor Market Conditions Index recorded 4 consecutive months of negative reading indicated that the labor market activities are really deteriorating.

 US Manufacturing PMI, closing to contraction territory while Non-manufacturing PMI drops to the lowest reading since Feb 2014.

 Italy’s April Service PMI dropped to the contraction territory of 49.8, first time since Dec 2014.

 France’s Manufacturing PMI already recorded 3 consecutive months of contraction since March.

 Almost all of the China’s economic data is trending down again. If the Chinese government decides to shift the focus from credit expansion to restructuring in 2H16, we might see more credit defaults or bankruptcy cases in coming 3-6 months.

On the other hand, we also see a lukewarm recovery case is still likely to happen given:

 As said in our previous report, we believe the FED has already changed the policy standpoint in March by choosing the risk of overheating the US economy over the risk of global economic downturn and they have already backed off its tightening bias for the rest of this year and we continue to believe there is no more rate hike for the rest of this year.

 US housing market is strengthening again and it can provide support to the overall economy.

 The latest GDP forecast by the US Atlanta Fed Reserve Bank has upgraded the 2Q GDP to 2.8% from 0.6% in 1Q.

 With a prolonged period of US dollar weakness (no Brexit case), it should give support to global commodities, RMB, and reflating Asian economies.

 We expect the latest VAT tax reform in China can stimulate domestic consumption in the 2H this year.

 As such, we might see a rebound of the global economic indicators in the coming quarters after a slowdown in 1H16.

Under this kind of 50/50 situation, we believe we have to continue to take a prudent risk management approach on our asset allocation strategy, especially the Brexit risk cannot be ruled out. We would continue to maintain our cash position at the current high level of around 45%-50%. In case the British finally decide to leave the EU, we probably will increase the cash further higher (but subject to the policy response from the Fed as Yellen has already indicated 2 days ago that they would consider using “helicopter money” policy to rescue the US economy from a severe downturn and we believe this policy would reflate the global risk assets again).

To repeat once again, there are two conditions that we would trim down our cash position aggressively to lower positions. One is the global economic leading indicators in the coming period reverse course to show more solid recovery signals and the other one is the valuation of the HSI falls to the historical distress level of around 7x PER, or 15000 to 16000 levels.

(source: Monthly Report, BASED AM, Jun 17 2016)