COVID-19: Trade tensions resurface

Equities markets finished last week on a downbeat note, with weakness spilling over into Monday trading, as US-China trade tensions resurfaced. On Sunday U.S. Secretary of State Mike Pompeo said there was "a significant amount of evidence" that the coronavirus originated in a laboratory in Wuhan, a claim which China has refuted. On 30 April, President Donald Trump threatened new tariffs on China, and said that China’s role in the spread of the virus now took precedence over the trade deal reached in January.

The potential for political risks to re-emerge in the wake of the COVID-19 crisis is one of the most frequent questions investors ask. In this article we address this issue and also answer more of the questions our clients are asking.

1. What political risks are on the horizon?

Pandemics have a habit of increasing mistrust of outsiders and minority groups. The growing political dispute between the US and China over the cause and spread of the pandemic is a clear example of this trend repeating. One manifestation is likely to be increased protectionism. A move toward increased protectionism could mean renewed focus by governments on the development or support of national champions through subsidies or tariffs on overseas imports. This is especially true for companies involved in goods that are deemed critical to public health, national security, or domestic prosperity. The virus crisis—especially amid renewed US-China tensions— also highlights the need for robust supply chains, and may tip the balance in favor of local production rather than global production for many companies. We expect this trend to create opportunities in automation and robotics as companies in high wage countries invest in local supply chains.

2. Is there a threat from a second wave of virus infections?

Equity indexes are now broadly pricing an outcome between our central and upside scenarios. In both scenarios, we expect the continued easing of lockdowns in the coming weeks. But in our central scenario, some restrictions may need to be intermittently reimposed for the remainder of 2020 to deal with renewed spikes in COVID-19 infections, and we only see a sustainable return to economic normality by the end of December. Germany and Spain, for example, have warned that restrictions would be re-introduced if new cases increased once more. In our upside scenario, some combination of digital tracking and drug treatments make possible future outbreaks easier to manage, meaning that lockdowns are lifted by the end of June and do not need to be reimposed.

Clearly, considerable uncertainty still exists about whether or not we see a second wave triggering renewed lockdowns. In this environment,

• We currently see greater opportunities in credit, which is generally closer to pricing in our downside scenario than equities, where there appears to be less margin for error
• Within equities, we continue to take a selective approach, favoring select cyclical stocks, stable defensive stocks, and the stocks of companies that should benefit from long-term secular trends, many of which will be accelerated by the COVID-19 pandemic.

3. How will consumer behavior be impacted by COVID-19?

In the near-term, government lockdown measures clearly act to suppress consumption. The effectiveness of policies to mitigate the immediate impact of the pandemic on employment will be important. The more workers who are furloughed rather than laid off, the more likely there will be a larger rebound in consumption as lockdowns are eased and pent-up demand is released. There are some encouraging initial signs. Around 30 million workers in Europe's largest five economies are now on government-backed furlough schemes, increasing the chances that they will return to work swiftly after lockdowns end.

But the longer-term impact of COVID-19 in changing consumer behavior permanently also needs to be considered. Once the crisis is over, consumers forced to shop online during the lockdown may not fully revert to use of brick-and-mortar shops, a boost for companies exposed to e-commerce and fintech. One of the most powerful trends over recent decades has been the emergence of the sharing economy. It remains unclear how quickly consumers and regulators will regain confidence in the safety of the sharing economy. For investors, the significant uncertainty around this trend—and how it might play out across industries—underscores the importance of diversification across sectors and companies.

4. Is the outlook for tech favorable?

Over our tactical time horizon of 6-12 months, we are currently underweight the US tech sector based on elevated valuations and concerns that the market is not fully appreciating the likely hit to enterprise IT spending from the pandemic. But our view on equities is to be selective given the significant rally in broader stock indices since the March lows. We expect the trend toward digital transformation to be accelerated by the pandemic, and selected areas of tech are likely to be among the beneficiaries of a more-digital world. We have already mentioned ecommerce, fintech, automation, and robotics as among tech sectors likely to benefit from changed consumer behavior and increased localization. Technology disruptors and enablers associated with digital transformation will also likely benefit, including companies exposed to trends like cloud, 5G, big data, and artificial intelligence (AI).

5. Should investors worry about a US debt crisis?

In our view, a combination of tax cuts and spending increases had already put US public finances on an unsustainable path even before the COVID-19 pandemic struck. The deep economic downturn caused by the pandemic, and the huge fiscal packages passed to help support the economy, have dramatically worsened the outlook. We expect the federal government budget deficit to exceed 20% of GDP this year, a level that was previously inconceivable in the absence of a war. While we are not in the "deficits don't matter" camp, in our view a debt crisis remains unlikely. By "crisis," we mean a situation where markets become unwilling to buy newly issued Treasuries at a reasonable interest rate. However, future tax hikes appear inevitable. The Federal Reserve may help by maintaining loose monetary policy for a long time, and we also expect moderately higher inflation, which will help reduce the nominal debt-to-GDP ratio. This means an environment in which investors need to consider alternative portfolio diversifiers to cash and bonds. We also expect increased importance on financial planning to manage the risk of higher taxes, and see a greater role for assets that can help protect against rising inflation.

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