Lull in trade dispute looks unlikely to last

Thought of the day

by Chief Investment Office 12 Aug 2019

No news was good news for global equities. The absence of fresh clashes between the US and China over the weekend contributed to a 1.8% rise in China's CSI 100 and a 0.1% move higher in the Euro Stoxx 50.

But the lull looks unlikely to last. We expect a volatile period for markets as trade tensions persist and markets look for offsetting stimulus from central banks. While face-to-face talks are set for September, US President Donald Trump on Friday told reporters these negotiations could be canceled.

We have updated our expectations following the US announcement on 1 August to impose further tariffs on Chinese imports, breaking the trade truce struck in June at the last G20 meeting.

  • Our base case, to which was assign a 50% probability, is that the US will press ahead with a 10% tariff on the remaining USD 300bn of Chinese imports not currently covered by a punitive levy. While this would represent an economic drag and cap the upside on global stocks, we believe the US economy can withstand the pressure and see only a 25% chance of a US recession next year. This would be partly due to efforts by the US Federal Reserve to support growth. In this scenario we would expect up to 75 basis points of additional Fed easing.
  • We assign a 30% probability to a worse outcome in which the US implements a 25% tariff rate on all Chinese imports. This move would be risky for the White House by increasing the chances of a US recession next year to around 50%, in our view. US companies would no longer be able to absorb the higher product costs into their profit margins, and consumers would be hit by much higher prices on goods. We estimate a drag of 100bps on US GDP growth and 50bps on Chinese GDP growth in 2020, even accounting for offsetting effects from domestic policy countermeasures.
  • The least likely next scenario, in our view, is a de-escalation, with the US not implementing the 10% tariff rate. This would lower the chance of a US recession to around 20% next year, and could allow the Fed to limit further easing to 50 basis points or less. In that event, we could see a further leg up of between 5% and 10% in global equities. Unfortunately, this outcome looks unlikely based on recent announcements, including China's decision to respond to tariffs by curbing purchases of US farm goods.So based on this set of expectations, we see limited short-term upside in global stocks. As a result, our overweight in them is balanced with counter-cyclical positions. We also favor a regionally selective approach, with an overweight in US stocks versus Eurozone equities – which stand to suffer more from weaker global trade.

Meanwhile, as central banks cut rates to support growth, we favor income-enhancing carry strategies, including a tactical overweight in selected high-yielding emerging market currencies versus a basket of lower-yielding developed market currencies. For more details, please see our latest Global risk radar: "US-China trade: Further from the truce."

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