Renewed optimism about a breakthrough on the US–China trade dispute helped push equity markets higher on 12 February after President Trump said that he could allow the 1 March deadline for increased tariffs to “slide” if “we’re close to a deal.” The S&P 500 gained 1.3% and closed above its 200-day moving average for the first time since 3 December.
But markets are pricing in a lot of good news based on expectations rather than actual delivery and we see reasons to remain cautious:
- Although recent trade negotiations between the US and China appear to be progressing, it is still far from certain that the trade dispute will be resolved and that US tariffs on Chinese products will not be increased in March. The same can be said about US negotiations with the EU. We see a 35% chance that further sanctions are implemented, notably an increase of tariffs on USD 200bn of Chinese goods from 10% to 25%, and/or tariffs on car imports.
- The Federal Reserve has paused the tightening cycle, but we still see a risk that rapidly rising US inflation could force the Fed to resume its rate hikes in coming months despite weakening economic growth, and against market expectations. Alternatively, if the US economy proves weaker than expected, there is a risk that even the current US policy rate of 2.5% turns out to be too high to sustain. Either of these risks could lead to a market downturn over our tactical investment horizon of six to 12 months. However, we consider both of these scenarios as unlikely for the time being (10%-15% probability).
- Our base case is for US corporate credit defaults to rise gradually in the base case, but not above long-term average levels (around 3.5% annually for US high yield bonds) throughout 2019. However, a shock to the US economic system, such as an inflation-driven Fed hiking cycle, could lead to a sharp rise in credit spreads with a knock-on negative impact on stocks (10%-20% probability).
- China is currently in both a cyclical and a structural economic slowdown. So far, economic data out of China suggests that this slowdown is being successfully managed through state policy intervention. However, if the full scale of US tariffs against China were implemented, the likelihood of a much sharper downturn in Chinese growth would increase dramatically. We assign a 10%-20% probability to this risk.In our base case, we still see a positive global outlook. The global economic expansion remains intact. And the 4Q US earnings season is progressing better than feared. We remain overweight global equities, but the numerous risks outlined above give us the conviction that it's prudent, for the investors who can, also to consider hedging.
For more on the risks facing markets see our latest Global Risk Radar, Late Cycle Musings.
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