• The US-China trade war has now escalated enough that our core views on economic growth stabilization are being challenged.
• We remain of the view that the US and global economies can avoid recession, but the risks to this view have risen in recent months. The ability of the economy to withstand further shocks is limited.
• Our key signposts now include US initial jobless claims and consumer confidence.
• We maintain a cautious stance on global equities and are neutral fixed income. The dollar should weaken as the US economy catches down to the rest of the world and Fed eases policy further.

In Investment Solutions, we take a theme-based approach to our multi-asset portfolios. We set out core views or hypotheses about the global economy and express these via sets of cross-asset trade ideas. Our themes are designed to be orthogonal; they should capture different elements of the global macro and market environment. We have now come to an interesting juncture in which one of our themes, the growing role of geopolitics and protectionism in markets, has become so strong that it is challenging our confidence in a second theme, that global growth will ultimately stabilize around its trend rate. Put simply, the US-China trade war is now a quite legitimate threat to the global and US economic expansion. 

While geopolitical developments have always played a role in economies and markets, their scale and impact has been steadily rising since the 2008 financial crisis. One way to quantify this is the Global Economic Policy Uncertainty Index, which has reached record highs, and is trending higher (see Exhibit 1 on the next page).

Traditionally, medium- to long-term investors have been able to compartmentalize the 'noise' of geopolitics and focus instead on the 'signal' of underlying economic fundamentals. However, the noise of trade escalation is arguably now the signal. Tariff policy has sent global manufacturing into contraction while business investment has declined sharply. The global economy continues to decelerate and is now quite vulnerable to another shock or miscalculation.

Exhibit 1: Global economic policy uncertainty trending higher

If there is some good news, it is that developed market economies are much more services-driven than manufacturing-driven versus history. Manufacturing today makes up only about 11% of the US GDP and 8.5% of US employment. And the services sector has, up to now, been rather resilient amid the deterioration in the goods-producing sector (Exhibit 2). But we are beginning to see some cracks in non-manufacturing, as measured by the global services PMI. If these PMIs can stabilize over coming months and specifically the services PMI remain above 50, as it has done in prior mid-cycle slowdowns, then our thesis on economic growth is intact. But risks are rising.

Exhibit 2: Manufacturing dips into contraction territory, while services stay near-trend

Source: Markit, Macrobond, UBS Asset Management. Green line= trend growth. Red line at 50 separates expansion from contraction. As of Sep 6, 2019.

The absolute key to whether the global economy can weather this geopolitical storm is the resiliency of the US consumer. As shown in Exhibit 3, the US consumer is about the same size in nominal GDP terms as is China's entire economy.

Exhibit 3: Nominal GDP of major economies

Source: UBS Asset Management, Macrobond as of 6 September 2019.

Consumption is a function of labor market incomes, which have decelerated but are in reasonable shape considering population growth and the length of the cycle. The risk scenario is that businesses, challenged by tariffs or other cost pressures, begin to cut back on labor. A rise in unemployment would sap consumer confidence, spending, and ultimately result in a recession.

So is our view that global growth will stabilize now invalid given the uncertain geopolitical environment? The answer for now, is no. We do not see enough evidence to suggest the US labor market or consumer is set to fold. While we look at a number of metrics, we find initial jobless claims a key leading indicator for the labor market and overall economy. Claims remain near historical lows and we would need to see a trend rise before turning more negative on the economy. Likewise, consumer confidence has tended to fall by more than 10% ahead of recessions. It remains near cycle highs—we are watching for deterioration here as well. Global growth stabilization remains the modal view, or base case, although the risks to that view have clearly risen. 

Exhibit 4: Key signpost 1—initial jobless claims near historical lows

Source: UBS Asset Management, Macrobond as of 31 August 2019.

Exhibit 5: Key signpost 2—Consumer Confidence remaining steady

Source: UBS Asset Management, Macrobond as of 6 September 2019.

A key related question is whether the world's central banks, which are now easing almost universally, are doing enough to stave off recession. Certainly, the abrupt shift from developed economy central banks has eased financial conditions, providing a healthy cushion for consumers and businesses.

China's recent announcement of new stimulus measures, designed to increase liquidity and boost infrastructure investment, is also helpful. We think this global monetary easing will be enough to stave off a recession, but the crucial determinant will be if there are further meaningful negative shocks related to trade policy or another catalyst. Central banks do not have the tools to fully offset more pressure on the global trade environment, and its indirect effects on business and consumer confidence.

Taking into account the rising risks to our base case on growth, we have a neutral outlook on global equities over the next 12 months and in some portfolios are tactically underweight. We are contrarian in our preference for European and Japanese equities relative to the US, as we believe that the former have much more bad news priced in. In fixed income we are also neutral, with a preference for US sovereign debt over that in Europe and Japan, as the Fed has more room to ease in a worsening growth environment. In line with this, we see the next big move in the dollar as lower, given it is overvalued and the US economy is 'catching down' to the rest of the world. We continue to be long the undervalued and safe-haven Yen and underweight the high beta Australian dollar as a hedge against further trade war escalation.

The chart below shows the views of our Asset Allocation team on overall asset class attractiveness, as well as the relative attractiveness within equities, fixed income and currencies, as of 30 August 2019.

Source: UBS Asset Management Investment Solutions Macro Asset Allocation Strategy team as at 30 August 2019. Views, provided on the basis of a 3-12 month investment horizon, are not necessarily reflective of actual portfolio positioning and are subject to change.

Source: UBS Asset Management. As of 30 August 2019. Views, provided on the basis of a 3-12 month investment horizon, are not necessarily reflective of actual portfolio positioning and are subject to change.