Market optimism over debt deal could set the stage for Monday’s selloff

(Bloomberg) – Markets are largely in the green on Friday, but strategists warn there’s still the possibility that U.S. debt ceiling negotiations could fail over the weekend or result in drastic spending cuts that slow down global economic growth.

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Assets in Asia are particularly vulnerable as they will be the first to react to any deal when they open on Monday, as the US will be closed that day for a holiday.

Republican and White House negotiators are making progress toward an agreement to raise the debt ceiling, but details remain tentative and they have yet to agree on the amount of the federal spending cap, according to people familiar with the talks. The spending cuts needed to get the Republican Party to agree on a deal could cost up to 570,000 jobs, according to a model from Bloomberg Economics.

“The outcome of any resolution will likely amount to a fiscal contraction that is not fully priced in by the market,” said Aninda Mitra, head of Asia macro and investment strategy at BNY Mellon Investment Management in Singapore. “When you try to rebuild cash balances like crazy, that accumulation sucks up liquidity at a time when markets have kind of whistled a little past the graveyard.”

Shares in Asia fell for three days through Thursday amid growing concern over a potential US default, and after Fitch Ratings said it could cut its AAA rating for the biggest world economy to reflect the heightened partisanship that is preventing a deal. Regional stocks rose on Friday, but that was driven more by a rebound in tech stocks than optimism about a potential deal.

Most of the regional markets are still down for the week amid declining risk appetite, led by emerging markets such as China, the Philippines and Malaysia. Materials and Consumer Discretionary stocks were also among the biggest losers.

‘Pandora’s box’

“We’ve never been in a default situation – that opens Pandora’s box a bit,” said Herald van der Linde, head of Asia-Pacific equity strategy at HSBC Holdings Plc in Hong Kong. “I can also see that the funds are saying we just don’t want to be in emerging markets and certainly not in smaller ones.”

Investors may want to stick to more defensive positions as there remains uncertainty over where planned spending cuts will be made, according to Invesco Asset Management.

“It makes sense to own strong cash flow, low volatility, defensive large-cap stocks such as healthcare and consumer staples,” said David Chao, global market strategist for Asia. -Pacific at the fund manager in Singapore.

Another potential refuge against a sell-off could be in some Asian bonds. The region’s investment-grade dollar debt spreads are at their lowest since mid-March, while an index of emerging Asian bonds outperformed a similar gauge of Treasuries this month, indices show. Bloomberg.

If there is a new sell-off triggered by a debt deal, Indian and Korean sovereign debt will likely outperform, said Ray Sharma-Ong, chief investment officer of multi-asset solutions at abrdn plc in Singapore. “Indian and Korean sovereign bonds are resisting US Treasury moves and will benefit from potential inclusions in the bond index,” he said, referring to ongoing reviews for those two Asian markets.

There is no certainty that a debt deal will end issuance, especially as bond markets potentially undervalue the risks associated with the final deal, according to Owen Gallimore, head of the Asia-Pacific credit analysis at Deutsche Bank AG in Singapore.

“Resolution can quickly turn into a sale,” he said. “This year’s bearish calls of doom in the credit market have not yet materialized, and the Asian market is trading tight spreads in this situation, so the risk-reward ratio is not good.”

—With help from Marcus Wong.

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