Risks to the global economy and markets have increased following a renewed escalation in US-China trade tensions. While attending a meeting of G7 leaders in France over the weekend, US President Donald Trump said the conflict with China was "in many ways…an emergency." Late last week, China and the US announced further increases in tariffs on each other's imports. After the market close on Friday, President Trump indicated that tariffs would rise to 30% from 25% starting 1 October on USD 250bn of Chinese goods already subject to levies. In addition, levies on the remaining, untaxed USD 300bn of Chinese imports will be subject to a 15% tariff, rather than the 10% rate previously announced, effective on 1 September for just under half of them and 15 December for the remainder.
We still believe the US can avoid a recession in 2020, helped by additional Federal Reserve easing and strong consumer spending. We estimate the direct impact of all the additional tariffs will represent only a marginal drag on the US economy. But downside risks are increasing for both the global economy and markets. As a result, we are reducing risk in our portfolios by moving to an underweight in equities to lower our exposure to political uncertainty. We continue to favor carry strategies in credit and foreign exchange markets, which benefit from central bank easing in a low-growth environment.
Our mix of underweight equities, hedges, and long yield brings us close to a risk neutral position. At this time, we would caution investors against large equity underweights as if they were preparing for a typical recession or the next Great Financial Crisis. We see the current scenario as different in several key respects.
What comes next?
The US-China trade dispute has escalated in recent days, raising the risk of a cycle of retaliation that undermines global growth and equity markets. That justifies a reduction in risk in our portfolios in order to lower our exposure to an uncertain political environment.
Investors will need to be responsive to evolving events. In particular, we will be monitoring the following factors to assess the need for further changes.
1. Signals from the White House:
The US president has proven capable of pivoting quickly, so it remains possible that a trade truce can be reestablished at short notice. This requires a flexible stance from investors. His statements on trade over the weekend sent conflicting signals. Speaking at the G7 gathering in Biarritz, France, President Trump responded to questions from reporters on the tariff increases by saying, "I have second thoughts about everything." To date, the president has followed through on proposed tariff increases only when the stock market was higher than when he announced the tariffs. A fall in markets could cause him to soften his stance. However, White House Press Secretary Stephanie Grisham said that President Trump's comments about having “second thoughts” had been taken out of context, and that he regretted not pushing tariffs even higher. We believe it is prudent to wait for a more stable policy environment before taking further action.
2. China's policy response:
China has previously responded to US actions without escalating the conflict. We believe China will avoid a hasty response to Friday's trade moves. But if the US follows through on its proposed tariff increases, China seems prepared to increase its measures in response.
3. Market reaction:
The S&P 500 closed 2.6% lower on Friday, in response to rising concern over US-China trade relations. But the market was closed by the time President Trump announced a further tariff hike. We would expect equity markets to come under pressure again this week as investors digest the latest escalation. As of Friday's close, US stocks were just 6% below the record high set late last month.
4. Policy response:
The Fed has been swift to offset the potential economic damage from the trade conflict, opting for an “insurance” rate cut at its July meeting. A broader policy response is likely if trade tensions worsen, including more aggressive easing from the Fed. For the time being, we expect the Fed to cut rates by 75 basis points over the next 12 months. But while central banks may be able to limit the downside to markets, we believe their capacity to push equities higher is fading. We also believe China's authorities have plenty of dry powder to support growth if needed, deploying both fiscal and monetary policies as well as allowing the yuan to move gradually lower.
5. Economic data:
We will be on the alert for signs that the recession in the global manufacturing sector is spreading to services and consumer spending. So far, while we expect a period of below-trend growth, we still believe that a US recession is unlikely in 2020. Fed easing and robust consumer spending are helping mitigate the damage from weaker manufacturing and investment. Interpreting economic data could become harder in the coming months if companies bring forward orders in anticipation of higher tariffs, creating the illusion of economic strength. In addition, we will be alert for signs that the latest tranche of tariffs could undermine consumer spending. We believe the new US tariffs will be more economically damaging than prior rounds of tariffs. While prior rounds largely covered industrial goods that the US could source from other nations, the latest round covers a range of consumer goods—including smartphones, personal computers, cameras, and clothing—for which it will be harder to find substitutes from elsewhere. This may be why the Trump administration decided to delay the imposition of part of the tariffs announced on 1 August until 15 December, to minimize the impact on pre-Christmas shopping. Higher tariffs on such goods could weaken consumer spending, which has been a pillar of strength of the US economy during periods of deteriorating business confidence and slower investment spending. President Trump may still decide to call a truce with China to limit the risk of a recession, which could undermine his chance of winning a second term in the November 2020 presidential election.
What does this mean for investors?
With talks between the US and China dominating market moves over the near term, investors should brace for higher volatility. We believe it is prudent to take action to neutralize part of this event risk, pending greater clarity on the outlook.
As a result, we make four changes to our US tactical asset allocation.
- We close our overweight to US equities. While US equities still look attractively valued relative to government bonds, uncertainty in the trade relationship between the US and China caps the upside for now. Although action by the Fed can minimize the downside, we are no longer confident that Fed easing will push stocks significantly higher. A shift in the outlook for trade talks, either toward further escalation or a truce or deal, could change this outlook rapidly.
- We initiate an underweight to emerging market stocks, while reducing our underweight to international developed market equities. Emerging market firms are more exposed to heightened market volatility, a slowing global economy, and heightened trade tensions. Developed market equities are also exposed to these factors, but certain markets, including Japanese and Swiss equities, should perform relatively better in down markets. This brings our overall position in equities to underweight.
- We initiate an overweight in US-dollar-denominated emerging market sovereign bonds. The spreads on emerging market bonds have recently widened slightly above their five- and 10-year averages. With central banks easing, higher quality credit should remain supported as growth slows. Spreads may widen further if trade tensions continue to escalate, but that will be partly offset by Treasury rates likely falling.
- Within our FX strategy, we adjust our overweight to select higher yielding emerging market currencies. We remain overweight the Indian rupee and Indonesian rupiah versus the lower yielding Australian and Taiwan dollars. But we remove the overweight to the South African rand versus the New Zealand dollar from this basket, due to increasing trade tensions and idiosyncratic risks.
We stand ready to make further changes as the US-China trade talks and market moves evolve. But while we think a reduction in risk is prudent, we note we are not bracing the portfolio for a traditional recession or the next Great Financial Crisis. While it is true that President Trump could send the markets higher if he tweeted he is ending the trade war, thus altering the probability weighted risk-reward, there are also more fundamental reasons to not position for a strong equity sell-off even if risk scenarios play out. In a more traditional economic cycle, a global slowdown spreading from the manufacturing to the service sector, coupled with geopolitical risks, would have warranted a larger underweight to equities. In the typical end of cycle, central banks raise rates to combat rising inflation, thus removing liquidity from the system. Today, however, inflation is tame and government bond yields are at historic lows. When pension funds and other asset allocators rebalance portfolios in the coming months, there are few alternatives to equities. Central banks are in easing mode and fiscal stimulus is also on the horizon. Thus, even if the manufacturing slowdown spreads to the wider economy, we believe the downside risk to equities is closer to 15% than 25%. Investors who try to time a rebound too perfectly are liable to do more damage to their portfolios than those who take the long view.