Key messages

Our main takeaways from the last week, plus investment considerations and economic events in the week ahead.

1. US tariff pause doesn’t mean the trade truce is back on.

The Trump administration announced that its latest raft of tariffs will cover only about USD 110bn of Chinese imports, as of September, rather than the USD 300bn initially threatened. The remainder is still set to be implemented in December. We see the announcement as a temporary reprieve, and not a return to the trade truce agreed by the US and China earlier in the summer. So far, President Trump has never rescinded tariff increases; he has only delayed them. Added to this, China has indicated that the tariff delay was not enough to prevent retaliation, backing our base case that a 10% tariff will be imposed on the full USD 300bn of Chinese imports by the end of the year. That said, we see the damage to the US economy as manageable – subtracting only around 0.25 percentage points from US GDP growth next year. We now expect the US economy to grow by 1.8% in 2020. Finally, the delay in US tariffs reinforces our view that the Trump administration is sensitive to the potential economic risks from the trade war, meaning that an escalation to a 25% tariff on all Chinese imports remains unlikely.

Takeaway: We balance our pro risk and carry positions with protection against tail risks – including a further escalation in trade tensions – in our tactical asset allocation. For more ideas on how to protect your portfolio against risks, click here.

2. Bond yields signal recession risk. That looks premature.

The 2–10-year portion of the US Treasury yield curve briefly inverted for the first time since the global financial crisis. This is traditionally seen as a harbinger of recession. But we believe recession fears are premature. Not every inversion has been followed by a recession – following three of the last 10 inversions, economic growth remained positive over the subsequent two years. And even when recessions have followed an inversion, the lags have been long and variable. Recessions start, on average, 21 months later, with a range of 9–34 months. Inversions don't provide a sell signal for equity investors. Since 1965, the S&P 500 returned an average 8% in the 12 months following a 2/10 inversion. Furthermore, a curve inversion may be even less likely to signal a recession this time around, as longer duration yields worldwide are being suppressed by the large volume of bonds held by central banks. That said, with trade uncertainty lingering, we do think bond markets are broadly right to be pricing in a longer period of weaker global economic growth, and lower interest rates for longer.

Takeaway: We expect further Fed rate cuts to steepen the yield curve back into positive territory, and we have a 12-month forecast of 1.8% for the 2-year yield and 1.9% for the 10-year tenor. Overall, we think this is a good environment for carry strategies. Investors focused on increasing their portfolio yield may want to consider our House View Yield-Focused Portfolios (PDF, 864 KB).

3. Political turmoil highlights the benefits of diversification.

A series of central banks from India to New Zealand followed the US Federal Reserve in cutting rates last week, while government bond yields continued to fall. Investors continue to price substantial rate cuts by the Fed this year. These policy rate cuts and subsequent market moves have left the yield on the 30-year US Treasury near a record low, and Austria's 100-year bond has now returned over 60% year to date. With the market indicating that rates could stay low for a generation or more, investors need to consider longer-term measures to increase the chances of achieving their financial goals. Holding excessive cash is becoming an increasing drag on returns, and prudent borrowing may start to play a more important part in investors' and entrepreneurs' financial plans, potentially boosting returns, reducing the need to sell higher return assets, and lowering the need to hold excess cash. For more, please see our report on borrowing strategies.

Takeaway: We think markets have gone too far in pricing in rate cuts, so we recommend a tactical overweight to cash versus short- and intermediate-term US government bonds. Even so, bonds remain an important aspect of managing equity risk, so we also recommend an overweight to longduration Treasuries.

Week ahead

Can China and the US avert a further souring of trade relations?

The debate is moving fast and China's government indicated late last week that it would retaliate to the latest round of US tariff increases. The magnitude of any retaliation could be important ahead of face-to-face trade talks with the US, which are due in September.

Will the FOMC minutes provide clues on future cuts?

The FOMC cut rates at the July meeting. The meeting was held before the most recent deterioration in trade tensions between the US and China. But we still expect the minutes of the meeting to signal further easing ahead. Next week we will also be expecting further evidence that the trade conflict is weighing on business sentiment, with flash PMIs for the US and Eurozone.

Will Italy's coalition survive?

On Tuesday Italy's Prime Minister Giuseppe Conte will address the Senate, which could lead to a confidence vote in the government. Deputy Prime Minister Matteo Salvini recently called his coalition government “unworkable” and vowed to force new elections. Political uncertainty has caused a widening of the spread between the yields on Italian government bonds versus German Bunds.


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