Keeping the market volatility in perspective

US-China Trade brinkmanship drives down markets

Author: Mark Haefele, Global Chief Investment Officer GWM, UBS AG

What happened?

After a weekend of confrontational trade rhetoric, China retaliated to last week’s US tariff increase, and markets fell sharply. From Friday's close through the end of trading on Monday, the S&P 500 was down 2.4% and the MSCI China Index fell about 3.8%.

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China increased tariffs on USD 60bn of US imports, with rates of up to 25%, and accused the US of "unilateralism and trade protectionism." In more negative news, US officials said preparations were being made to apply new tariffs to the remaining USD 325bn of Chinese imports not yet covered by levies. While President Donald Trump warned that China would be "hurt very badly" if it does not agree to a trade deal, it's important to note that it should take about two months for the Trump administration to follow through on this proposal.

As Sino-US tensions mounted last week, we closed our overweight to emerging market hard-currency bonds to further manage risk. But while the path to a potential agreement is likely to be bumpy, and investors should brace for further volatility ahead, our base case remains a positive outcome to trade talks. We therefore recommend that investors remain invested, and caution against taking drastic action based on trade headlines alone.

What are we looking for next?

As we described in our 9 May House View update, we believe market moves from here will hinge on 1) whether trade negotiations continue or break down completely; 2) how swiftly the US follows through on the president's threat to impose duties on an additional USD 325bn of Chinese goods; 3) whether China retaliates beyond the tariffs announced on 13 May; 4) whether the US goes on to raise tariffs on auto imports; 5) the monetary and fiscal policy response; and 6) the spillover, if any, for global economic growth.

While companies have managed to work around the previous rounds of tariffs —tweaking supply chains and rerouting goods—we've already seen some damage to smaller businesses, and the pain could spread if the scope of tariffs widens. Earlier rounds intentionally excluded goods that the US sources primarily from China. We will also be watching to see how escalation impacts business sentiment and whether it prompts firms to delay investment. We estimate that if all Chinese goods are subject to a 25% tax, US economic growth would drop by 0.75–1%, S&P 500 profits would grow about 3% slower than in our base case forecast, and US equity markets would fall by about 10–15%.

However, negotiations are at least continuing. President Trump's top economic advisor, Larry Kudlow, said there was a "strong possibility" that the US and Chinese presidents would meet at the G20 summit in Japan next month and that talks remained "constructive." It's also a good sign that China's retaliation has been relatively muted, mirroring measures that were first outlined as far back as September, when the US initially threatened to add to tariffs on USD 200bn of Chinese imports. China has not yet indicated it will bring back higher tariffs on US auto imports, which were lowered in December after an amicable meeting between Presidents Trump and Xi Jinping. China has also so far refrained from declaring its intention to stop purchases of US agricultural goods—another goodwill gesture after the December presidential meeting.

How should investors respond?

Our tactical overweight to long-duration Treasuries has rallied about 1.7% since 3 May, helping to offset equity losses during this period of volatility.

We will continue to assess the need for further downside protection, but continue to believe that a shared desire to avoid a global slowdown will push the US and China toward a compromise. However, the path to agreement is likely to be bumpy, and we will need to monitor the risk that President Trump begins to view the political benefits of a tough stance against China as more than offsetting the economic risks.

Therefore, as we detail in Be prepared: Plan, Protect, and Grow, volatility and uncertainty may persist, so investors need to protect against near-term 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. We recommend against too much credit risk in bond portfolios, but 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.

For capital devoted for long-term objectives, 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 monitor our positioning and make adjustments as warranted by an evolving risk-return outlook, and keep you informed.