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This time last year, we were looking at how trade relations between the US and China might play out and the best way to position a portfolio – especially in terms of sectors – according to which scenario an investor thought was most likely.
What has really changed in the past 12 months? Aside from the main protagonists turning up the heat a fair few degrees, the biggest difference can be seen in the sharp reduction in economic growth. In this article, we will revisit the most likely scenarios and focus on the potential macro implications to give us a steer towards asset classes worth considering.
The three possible scenarios highlighted by Invesco’s asset allocation research team last year were:
- A full-scale trade war that also negatively impacts other countries outside the US and China;
- No all-out trade war, but a selective application of tariffs to a limited number of products;
- China and the US both stand down without any repercussions.
The ever-widening range of tariffs introduced by both sides make the odds seem heavily skewed towards the first two scenarios. You could argue that tension between the world’s two largest economies seem to play into the political agendas of both Presidents Trump and Xi, with neither willing to yield ground to the other, and both trying to claim victory. With the most comprehensive list of tariffs introduced at the end of August, the stage looks set for when the two sides square off at the negotiating table in September. However, we do not expect this to be the final scene.
The global economy has taken the hit
The biggest casualty of the war so far has been the global economy, which we flagged as the main probability in our outlook a year ago. There is no doubt that the slowdown in growth is the result of a reluctance for the manufacturing sector to commit investment, due to the uncertainty related to the escalation of the trade war and the possibility that US companies may be forced to relocate factories and operations currently based in China. We expect the global economy to remain sluggish.
The Fed has suggested that it is prepared to loosen monetary policy further if necessary, although chairman Jerome Powell has stressed that the central bank is not responsible for supporting trade policy and has warned that the Fed may not be able to counteract the effects of an all-out trade war. On the other side, we see a Chinese economy that appears capable of continued growth even with tariffs in place.
China has imposed tariffs on agricultural commodities imported from the US, which it can easily source elsewhere, but which directly hurts the US farming community. Meanwhile, Trump’s attention has so far been on the big Chinese technology companies to protect the intellectual property of US firms and due to what the US president sees as security risks. More generally, tariffs have been placed on raw materials and manufacturing components, including semiconductors, but have now been expanded to include just about everything made in and imported from China.
Winners and losers?
The question for investors to consider is who ultimately pays for these increased costs. It is unlikely that low-margin industries can absorb the costs, so they will have to pass them on to consumers, whereas bigger ticket items like white goods may see consumers simply defer purchases. Expect this to translate into lower consumer spending, a deterioration in both consumer and business confidence, and lower corporate profits and margins across several key industries. If costs are eventually passed along to consumers, especially on staple goods, we could see an uptick in inflation.
Bonds, gold and no automobiles
Deciding the best way to position a portfolio depends on your outlook and how much risk you are willing to take. While that task is made more difficult with the growing market uncertainty, high-quality government bonds and gold are generally useful tools for diversification and may be able to help cushion the downside risk within portfolios that are heavily exposed to equities.
Fixed income is typically one of the first places investors turn to when equity markets are volatile. US Treasuries and other high-quality government bonds tend to offer relative security, although current low yields mean they may not offer much value. Other fixed income segments may be more attractive for investors looking for higher yields and who are able to take more risk. This ranges from investment grade credit to high yield but also could include more innovative segments such as Additional Tier 1 (AT1) bonds.
Investors who do not need income may instead think about gold, which has long been viewed as a relative ‘safe haven’ during volatile and uncertain times, with historically low correlation with risk assets. The fact that gold does not pay an income is not an issue in the current environment with interest rates already low and potentially moving lower if economic conditions worsen. In fact, real yields on some government bonds are now in negative territory, making a zero-income asset such as gold even more attractive on a relative yield basis. Exchange-traded products that invest in physical gold offer a cost-effective way for investors to gain exposure.
In terms of equity allocation, markets will remain sensitive to trade-related developments as well as more general economic data, so investors should be prepared for some volatility. The US and China equity markets should react the most, to both good and bad news, so investors who believe that the two nations will manage to avoid an all-out trade war may see market dips as possible entry points.
If you are considering a sector allocation, the more defensive sectors such as consumer goods, telecoms and utilities are likely to hold up relatively well during volatile periods, while cyclicals would normally be expected to lag. This is especially relevant given the weakness in manufacturing, as industrials, tech and consumer discretionary sectors, especially autos, are potentially susceptible to a general slowdown in the economy.
For those who believe that trade tensions will ease or who expect an agreement to be reached between China and the US, the recent pullback in equity markets may offer a buying opportunity. Many companies could benefit from an advantageous trade agreement, including US technology firms if their intellectual property rights are protected, while companies across sectors may find themselves on a level playing field with their international competitors. That scenario is not only possible but may benefit both countries in the long run. However, it may be a little while off.
Gaining exposure to express your view
Whatever view you have of the economy or how you believe the trade war will impact investment markets, you should be able to find an exchange-traded fund (ETF) that helps you gain exposure efficiently. From low-cost gold products and government bond funds to more innovative strategies to access niche segments of the market, including individual equity sectors, ETFs offer wide choice, intraday trading and cost-effective exposure.