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Should you chase this rally?

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One potential disappointment is that the trade agreement could look more like a ceasefire than a peace treaty, and widely held expectations for an immediate roll-back of existing US tariffs might not happen.

Singapore

GIVEN the sharp rally over the year to date, we are growing more circumspect about the market's risk-reward at this juncture as equity valuations appear less attractive while risks over Sino-US trade and global growth continue to linger in the background.

Generally, we think that this is not time to add risk and chase the rally, and we would prefer an entry point with better risk-reward and more clarity on Sino-US trade.

Earlier in April, in terms of our asset allocation strategy, we have taken some profits off the table by reducing our total equity allocation from 44.8 per cent to 42.4 per cent (which remains overall mildly over-weight due to our positions in laggards Europe and Japan.)

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One key factor driving this rally has been increasing market optimism over a Sino-US trade deal, resulting from both US and China policymakers steadily hailing substantial progress on negotiations.

While a positive deal is certainly possible, the danger is that the market is vulnerable to disappointment after aggressively pricing in a decisive and concrete trade resolution.

One potential area of disappointment is that the trade agreement could look more like a ceasefire than a peace treaty, and widely held expectations for an immediate roll-back of existing US tariffs might not happen.

The list of fundamental and complicated demands from the US points to the need for monitoring and enforcement mechanisms; and this could mean that some if not all of the existing tariffs will only be rolled back if the Chinese hit pre-agreed targets in the years ahead.

Those anticipating a quick deal might also be disappointed. Already, earlier hopes of a deal and summit in March have been dashed, and with each further delay, it is becoming clear that both sides need significant time to iron out final details.

The Chinese now face less pressure to strike a fast deal as their economy begins to show signs of stabilisation and they now have greater leverage to push back against US' demands for verification and the right to exercise unilateral punitive actions ahead, which is seen to be an assault on China's sovereignty.

This market rally also faces additional uncertainties as it enters the Q1 2019 earnings season.

With Q1 estimates coming down over the last few months, earnings per share for the US (S&P500) and Europe (Stoxx600) are estimated to fall year-on-year for the first time since 2016.

The good news is that current consensus estimates look achievable.

Unlike during the Q4 2018 earnings season, however, when we saw many companies reporting weak results rallying as the market was oversold and valuations were far more attractive, we are now heading into Q1 2019 earnings with a higher bar after a sharp market rebound and higher valuations.

To drive the rally further, investors will need to see evidence of a 2H rebound in earnings growth, and company guidance will be in focus.

This is especially so as the rally in equities this year has been solely driven by price-to-earnings multiple expansion (which is now near one standard deviation above its seven-year average), and the scope for further multiple expansion is increasingly limited.

Company margins will also be a potential source of concern for the market. Margins enjoyed a one-time boost from tax reforms in 2018, but margin expansion will be increasingly hard to see in a very tight labour market with rising wage pressures. This will be something to monitor closely in the weeks ahead.

  • Eli Lee is Bank of Singapore's head of investment strategy; Conrad Tan is investment strategist.