Macro Monthly Q&A on recent market developments

• The most recent step-up in trade tensions heightens the risk of a non-linear escalation and we remain cautious on global equities.
• That said, we are not concerned about China's authorities allowing the yuan to depreciate past 7, nor the US's largely symbolic decision to label China a currency manipulator.
• At this point, the state of trade talks can improve just as quickly as it can deteriorate. We expect markets to remain volatile through the rest of the summer.
• We are of the view there should be more risk premium reflected in the US dollar, given the change in US foreign exchange policy and intervention risks.

Global markets remain fluid amid the US-China trade war escalation, the depreciation of the Yuan past 7 per dollar, and the US labeling of China as a currency manipulator. There are a lot of moving pieces, so we deliver this Macro Monthly in a Q&A format to efficiently share our thoughts on recent developments and what it means for asset allocation.

Why did risk assets sell off so aggressively after President Trump’s August 1st tweets on US-China trade?

In our view the severity of the market reaction has less to do with the direct economic effects of a possible 10% tariff on the remaining USD 300 bn in Chinese imports, which is likely to take a few tenths off of US, China and global GDP. Rather, we believe that markets are disturbed by the risk of non-linear outcomes of further escalation in both trade and technology. From the US side this includes a full 25% tariff on all Chinese imports (which could potentially be the last straw for a vulnerable global economy) or restricting sales of semiconductors to a wide range of Chinese companies. From China’s side, limitations on the sale of rare earths to US companies or prevention of particular US companies to operate or sell in China (known as the unreliable entities list) would also create significant disruption. All of these next potential moves risk major disruption to the trade and technology relationships of the world’s two largest economies, with ripples across global supply chains.

The severity of the next moves in the trade war rings of ‘mutually assured destruction.’ In other words, any of the above steps would probably inflict meaningful pain not just on the receiving party but on the acting party itself. As such we view such escalations as unlikely, while acknowledging that markets must place some risk premium that they do happen. Domestic political pressures not to back down are present on both sides, as are risks of miscalculation. Our base case is that cooler minds prevail—now that the stakes have risen so high, the economic and political costs of further escalation on both sides are significantly larger than the benefits.

What is the significance of the Yuan’s depreciation past 7 per dollar?

The 7 level in USD/CNY was viewed as a symbolic line in the sand. The onshore exchange rate had not traded beyond 7 since March 2008 and Chinese authorities have generally guided the market not to breach that level. Following President Trump's latest tariff threat, Chinese authorities allowed the currency to surpass 7, sparking concerns that they would permit a sharper depreciation catalyzing broad FX weakness (and USD strength) that would lead to a sharp tightening of financial conditions for the US and emerging markets. However, we believe that China’s decision to not set the CNY ‘fix’ weaker than market expectations in the following Asia morning signals that authorities are not looking to use the currency as an active weapon going forward, at least not at this point.

The reality is that despite the benefits of currency weakening to offset the effects of tariffs on companies, there are costs as well. China’s authorities do not want to spark a sharp pick up in local outflows, which could disrupt financial stability. Moreover, China is still prioritizing opening up its markets to international investors, both official and private, and would not want to send a message of instability. Finally, a sharp CNY depreciation would make goods more expensive for Chinese consumers. For these reasons we see China’s recent allowance of a weaker currency as a warning shot to the US administration, as opposed to the start of a devaluation campaign.

What is the significance of the U.S. labeling China a currency manipulator?

On the day China allowed USD/CNY to slide past 7, Treasury Secretary Mnuchin officially labeled China as a currency manipulator (the first time Treasury had taken that step in 25 years). The timing of this move is somewhat ironic in that China had for months and years been taking steps to prevent its currency from weakening and the move beyond 7 was actually in line with market forces after the tariff threat. While the Treasury Department’s step was unexpected and unlikely to be taken well by Chinese authorities, it is more symbolic than anything. The Treasury Department will engage in dialogue with the IMF and China over an entire year on steps that should be taken to alleviate trade imbalances. After that year, the President has some authority to impose penalties on China, but the scale of current and proposed tariffs on Chinese imports make those actions look minor in comparison.

What is happening with US dollar policy?

The Treasury's currency manipulation announcement is just part of a broader evolution in US dollar policy under the Trump administration. The President has verbally criticized China and Europe for competitive devaluations, demanded commitments not to devalue in trade agreements, and recently tasked aides to find ways to weaken the dollar. This is a meaningful departure from the implicit strong dollar policy or at least a laissez faire one that has governed US FX policy for 25 years. The executive branch, via the Treasury Department, owns the right to intervene in foreign exchange markets. It is possible, especially in reaction to further dollar strength, that the President could authorize intervention to sell dollars against the offshore yuan, euro and yen. If the Fed were to act in concert with the Treasury, as it has done historically, the Treasury could sell about USD200 bn into into foreign currency. Such a move would shift the dollar lower in a knee-jerk fashion, and the signal has the potential to carry a more pronounced depreciation.

How does the Fed fit into all of this?

The Fed shifted to an easing stance in May, largely due to growing downside risks associated with slower global growth and trade tensions (along with persistently low inflation). These risks were magnified when the President delivered his tweet, just one day after the Fed had cut rates for the first time since 2008. The President continues to demand easier Fed policy and is likely to get it especially after the tightening in financial conditions that followed the most recent uptick in trade tensions. We suspect the Fed will ease by an additional 50 bps by year end. However, the bet that Fed easing will continue to offset growing economic and financial market damage is a risky one. Fed easing impacts the economy with long and variable lags, while trade risks are a here and now for companies and consumers.

What are we watching?

Markets are likely to remain volatile for the rest of the summer and conditions can improve just as quickly as they can deteriorate. In the very near term, we are focused on whether the US Commerce Department issues some partial waivers to permit American companies to continue shipping products to China's Huawei. This was part of the original deal out of the G20 in Japan, along with China agreeing to step up purchases of US agricultural goods. Such a move (and ensuing agricultural purchase) would significantly de-escalate tensions and probably lead President Trump to scrap the plan to increase tariffs on September 1st. Of course, the imposition of tariffs in September would be negative for global growth, risk assets and the path forward for US-China relations.

What does this all mean for asset allocation?

We moved neutral equities in May and in some portfolios went underweight after the July G20. Our view was that a lot of good news was in the price, leaving markets vulnerable to negative surprises on growth, central bank action or trade tensions. We maintain a cautious stance, given that meaningful uncertainties remain in the near term. That said, we do think developed market consumers are fundamentally in good shape and do not anticipate a recession over coming months. With that backdrop, expectations for Fed easing have become a bit too aggressive and we have an underweight stance on duration over the next 12 months. In currencies, we remain underweight the dollar which we think should have greater risk premium attached to it given intervention risks.

Asset class attractiveness

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 July 31, 2019.