Markets & regions: Using ETFs to position for a US–China trade war
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Many media and market commentators believe that the potential US-China trade war could be one of the largest risks facing the global economy. And while the degree to which relations deteriorate is unknown, many investors are understandably exploring how best to position their portfolios amidst the potential economic impacts.
In this article, we explore the sectors and asset classes likely to benefit and suffer across a range of trade tension scenarios, why exchange-traded funds (ETFs) are a useful tool for implementing the sort of nuanced investment exposures that are required for such scenarios, and how an investor might implement these targeted views.
Advantages of ETFs for targeted views
ETFs are unique in many ways. One unique feature is the granularity of exposure many ETFs offer. As most ETF assets are held in broad index trackers, many investors are unaware of the rich offering that exists in more narrowly focused funds. These ETFs can be used as ‘satellite’ investments around investors’ core exposures to help fine tune portfolios to specific market or economic investment views.
Take sector-specific ETFs for example. Due to these ETFs’ different sensitivities to macroeconomic factors, geopolitical shifts and other news flow, many investors use sector over- and underweights to position their portfolios according to their views.
Why might an investor use an ETF over an actively managed sector-specific fund? Sector-specific ETFs have several advantages over actively-managed funds. First, ETFs provide easy access to a full range of sector exposures, and many passively track indices at lower costs. When compared to achieving the same exposure via an active manager, an ETF may help reduce the need for lengthy due diligence across many different managers. Many sector specific active fund managers are boutique firms that lack a full range of sector funds, and so investors in these active funds may expend more time and resources performing due diligence.
By using passive replication, ETFs act as tools for pure directional positioning. This may mean less or no unintended conflict between the sector ETF exposure and the positioning or view of the end investor – many actively-managed sector funds are run as a long/short strategy to increase the opportunity for outperformance, but therefore provide less pure directional exposure.
Another advantage of sector ETFs is breadth of choice. For example, the most actively traded sector range in the US offers 11 different funds, and, in Europe, there are 18 funds in the most popular sector family. There is also a wide range of ETFs that track less traditional sectors (for example, fintech, master limited partnership or MLPs) and more thematic indices (for example, exporters).
Lastly, ETFs offer benefits because of how they trade. Sector views tend to be more tactical and short term than broader regional or asset allocation decisions. ETF investors can respond to news quickly, even intraday, and have no mandatory holding periods or pre-defined redemption windows. ETFs are designed to accommodate this type of high turnover trading.
Whether it’s easy access through less due diligence, pure directional positioning, choice or trading, for investors seeking nuanced investment exposure, granular ETFs, such as sector ETFs, may be the preferred investment vehicle.
Possible scenarios and positioning for a US-China trade war
The recent US-China trade tensions provide a convenient framework for examining how investors can adjust their portfolio to express their views. Our Multi-Asset Economic Research Team has identified a scale of scenarios:
• 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 most likely scenario is not an all-out trade war, but a selective application of tariffs to a limited number of products. This would be likely to drag on global economic growth and push inflation up in the US as higher imported costs are passed on to consumers. Under this scenario, we expect domestic companies would fare better than exporters. Defensive sectors such as consumer staples, utilities, or healthcare, would likely outperform cyclicals such as banks or technology.
Tariffs will impact more than sectors. For investors asking broader allocation questions, from a geographical perspective, the question remains: is the trade impact contained to just the US and China? If so, one could argue the case for select European equity sectors.
For investors looking to invest directly into China, we believe the impact of selective tariffs on the overall Chinese economy is likely to be moderate. Investors may view the broad sell-off in Chinese equities over the past six to eight months as representing a fair assessment of this impact, or alternatively as an overreaction and therefore an attractive opportunity to invest.
The other two scenarios to consider are the extrema. The worst-case scenario is a full-scale trade war that would negatively impact other countries. This could lead to a global recession that would be particularly damaging for commodities, equities, and emerging markets. At an asset class level, the relative winners are likely to be ‘safe haven’ asset classes such as gold, Treasury bonds, and cash. In terms of equity exposure, the worst-case scenario would favour domestically-focused defensive stocks. Sectors such as healthcare, utilities, telecoms, and consumer staples would be likely to hold up much better than cyclicals. China A-shares in this case would be expected to underperform, in particular the more export-focused industrial and technology sectors would suffer.
At the other end of the spectrum, there is the extreme outcome of a happy ending in which both China and the US stand down without any repercussions. If this were the case, it would be a relief for global equity markets in general, and particularly for the US and China. Chinese equities would benefit, and the broad sell-off in Chinese equities over the past six to eight months could be an attractive entry point. The most attractive sectors would be those that benefit the most from continued strong global growth. These include highly cyclical sectors such as basic resources and those that are most hurt by rising inflation, such as utilities.
What stands out is that it’s likely the winners and losers would be sharply divided across the scenarios, based on whether they are exporters versus domestically focused, cyclical versus defensive, and more versus less inflation sensitive. For investors following the markets, new information comes quickly and can have a significant impact on relative sector performance.
ETFs provide a ready toolkit with which to easily realign portfolio exposures – whether to increase exposure to target sectors or reduce exposure to potential underperformers. The granular nature, wide offerings, and flexible trading characteristics of ETFs allow investors to be nimble, especially in preparation for today’s burgeoning US-China trade war.
Matthew Tagliani is head of ETF product and sales strategy at Invesco