US-China dispute: Taking action to manage risk

Thought of the day

by Chief Investment Office 10 May 2019

To manage our portfolio risk, we have closed our overweight in emerging market hard currency sovereign bonds versus US government bonds. This move came ahead of the US decision to increase tariffs from 10% to 25% on USD 200 bn of Chinese imports. China has vowed to retaliate, although at time of print details remain vague. While a U-turn is still possible, we may face a period of uncertainty and increased volatility. The US-China rivalry remains deep-seated.

What's going on with negotiations?

As expected, first-day talks between China's Liu He and US negotiators Robert Lighthizer and Steven Mnuchin failed to yield a breakthrough. Negotiations will resume Friday morning under the shadow of higher US tariffs, with the US Customs and Border Protection agency confirming a 25% duty would be imposed on US-bound cargoes leaving China after 12:01 EDT Friday. The two to three week delay before tariffs start to be collected, which reflects shipment time from China, offers a potential window of opportunity to reach a deal before the levies take effect. At time of print, the Chinese delegation said it “deeply regrets” the US tariff hike and that it would take “necessary countermeasures,” but so far has yet to detail planned retaliation.

With new tariffs implemented, the direction of markets from here will hinge on: 1) how China retaliates; 2) whether trade negotiations continue or break down completely; 3) whether the US begins groundwork on following through on the president's threat to impose duties on an additional USD 325 bn of Chinese goods; 4) whether the US goes on to raise tariffs on auto imports; 5) the monetary and fiscal policy response; and 6) the spillover for global economic growth, if any.

Why are we taking action to mitigate risk?

The week's events have shown the lack of stability in US–China trade relations. A return to tit-for-tat tariffs between the US and China represents a threat to the global economy and equity markets. Uncertainty over trade policy has been partly responsible for the recent slowdown in global trade and industrial output, and higher tariffs, if sustained, could also impact corporate profits globally.

With this in mind, we are making one adjustment to our portfolios to help manage risk. We close our overweight in emerging market hard currency sovereign bonds versus US government bonds. The spreads on emerging market bonds have remained resilient even as trade tensions have escalated, a testament to their solid fundamentals, but the spreads are likely to widen if additional tariffs increase growth concerns. In contrast, US Treasury bond yields are likely to fall in that scenario. This adjustment reduces some risk in the portfolio without giving up much upside if a trade agreement is reached.

After this week's decline in markets, isn't the risk already priced in?

US markets are down 2.5% from the 30 April all-time closing high, and Chinese stocks are down 4.7% over the same period.

However, this is a relatively modest decline in the context of strong performance this year, and there is the risk of additional downside if we see significant retaliation by China, a breakdown in talks, and the imposition of further tariffs. In this scenario, we would expect a fall of around 10%– 15% in US equities and 15%–20% in the Chinese market. Trade-exposed sectors could suffer the most, including technology, industrials, and energy. We would also expect an appreciation in the Japanese yen, with the euro, Australian dollar, and emerging market currencies likely to be negatively impacted.

Why aren't we reducing risk further?

Our base case remains that the US and China will eventually reach some kind of accord. Both the US and China have strong incentives to reach a deal and we do not expect a complete breakdown in negotiations. We believe China may have overestimated the US desire for a swift deal, and is eager to repair the process. If so, any retaliation from China would likely be moderate. Equally, President Trump is eager to avoid a large fall in US markets, or damage to the economy ahead of the 2020 presidential election. Meanwhile, we should remember that the Federal Reserve and Chinese authorities can help mitigate the economic effects of continued trade uncertainty.

In addition, after this week's decline in markets, some risk is now already priced in. From here, we believe that markets would be reassured by a measured response from China, indications over a new time frame for a conclusion to talks, and an absence of preparations for further tariff hikes from the US.

As such, while we make adjustments to our portfolio to manage downside risk, we are not taking an outright negative stance at this time. Our overall tactical positioning is now slightly positive on risk, with overweight positions in emerging market and Japanese equities, offset by a counter cyclical position in long-duration Treasuries. Within US stocks, we are also moderately underweight the industrials sector, which is more sensitive to trade fears.

How should investors respond?

As we discussed in Plan, Protect, and Grow, there is potential for volatility and continued uncertainty ahead, and investors need to protect against nearterm risks while also staying invested for long-term portfolio growth.

High-quality bonds (Treasuries and municipal bonds) are portfolios' primary defense against equity market risk. While we recommend against too much credit risk in bond portfolios, we do see several opportunities to manage risk and enhance income; for example, multilateral development bank bonds and green bonds can provide a similar yield pickup while managing risk (with the added benefit of contributing to global development and environmental goals). Cash is not an effective shield against potential market volatility, so while investors should keep enough cash set aside to meet financial goals over the coming two to five years, they should invest the remainder in a balanced and well-diversified portfolio.

To enhance portfolio growth, we recommend that investors tap into secular growth trends – for example, through the Quality Growth at a Reasonable Price (Q-GARP) and Midcap CIO equity model portfolios – and invest in enduring trends through our Long Term Investments (LTI) series, our House View Sustainable Investing portfolios, and specific investing themes such as Enabling Technologies, Fintech, and Sustainable Value Creation in Emerging Markets. We will continue to make adjustments to our positioning as warranted by an evolving risk-return outlook, and keep you informed.

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