Market optimism on the debt deal could pave the way for a sell-off on Monday

(Bloomberg) – Markets are largely in the green on Friday, but strategists warn there is still a chance that US debt ceiling negotiations fail over the weekend or result in draconian spending cuts that slow global economic growth.

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Assets in Asia are particularly at risk as they will be the first to react to a deal at Monday’s opening as the US is closed for a public holiday that day.

Republican and White House negotiators are making headway toward an agreement to raise the debt limit, but details remain preliminary and they have yet to agree on a cap on federal spending, people familiar with the talks say . Spending cuts needed to get the Republican side to agree on a deal could cost up to 570,000 jobs, a Bloomberg Economics model shows.

“The outcome of any resolution is likely to be a budget cut 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. “If you’re going crazy trying to rebuild cash, that build-up sucks liquidity at a time when markets have been a little rattled.”

Stocks in Asia fell for three days into Thursday as concerns mounted over a potential US default and after Fitch Ratings said the AAA rating on the world’s largest economy could be downgraded to reflect rising partisanship wear that prevents an agreement. Regional shares rose on Friday, but that was more on a rebound in tech stocks than optimism over a potential deal.

Most of the regional markets are still down this week on easing risk appetite, led by emerging markets like 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 – it’s opening a little bit of Pandora’s box,” said Herald van der Linde, head of equity strategy for Asia Pacific at HSBC Holdings Plc in Hong Kong. “I can also imagine funds saying we just don’t want to be active in emerging markets and certainly not in smaller ones.”

According to Invesco Asset Management, investors may want to hold on to more defensive positions as long as uncertainty persists over where expected spending cuts will be made.

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

Another potential haven from a sell-off could be some Asian bonds. The region’s investment-grade dollar bond spreads are the tightest since mid-March, while an index of emerging-market Asian bonds beat a similar benchmark for government bonds this month, according to Bloomberg Indexes.

If another debt deal sells off, Indian and Korean government bonds are likely to outperform, said Ray Sharma-Ong, investment director for multi-asset solutions at abrdn plc in Singapore. “Both Indian and Korean government bonds are resilient to US Treasury actions and will benefit from potential bond index inclusion,” he said, citing the ongoing reviews of these two Asian markets.

According to Owen Gallimore, head of credit analysis for Asia-Pacific at Deutsche Bank AG in Singapore, there is no certainty that a debt deal will spell the end of things, especially as bond markets may understate the risks associated with the final deal.

“The decision can quickly lead to a sell-off,” he said. “Downtrends this year due to the credit market issues have not materialized yet and the market in Asia is trading with tight spreads in this situation so the risk/reward trade-off is not good.”

– With the support of Marcus Wong.

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