Familiar themes, new twists

Shifts in the US–China trade dispute and Federal Reserve monetary policy have been the dominant market drivers this year. Global equities rallied in June and July on rising hopes of Fed rate cuts, and after the US and China reached a trade truce at the G20 summit.

But equities have since fallen 3.5% from their July peak, after falling by as much as 6%. The Fed's 25 basis point (bps) reduction in interest rates on 31 July disappointed hopes for more aggressive action. A day later, President Donald Trump reignited the trade dispute, threatening a 10% tariff on the remaining USD 300bn of US imports from China, and subsequently labelled China a currency manipulator.

Where markets head next will largely hinge on whether the threatened tariffs are implemented, and how the Federal Reserve responds. We see three main scenarios.

1. Upside case (20% prob.)

• The most positive outcome would be de-escalation. China could offer concessions, for example by buying additional US agricultural products, deemed sufficient by President Trump to remove the threat of new tariffs, or even roll back some existing tariffs and sanctions. But this appears highly unlikely. President Trump has threatened fresh tariffs because, in his view, China has reneged on promises made as part of the truce. And rather than appearing willing to make concessions, China has currently suspended US agricultural imports, allowed the yuan to weaken beyond USDCNY 7.0, and warned of proportional retaliation if tariffs are imposed. Given these tit-for-tat responses, de-escalation appears unlikely for now.

2. Base case (50% prob.)

• If China doesn’t offer concessions, President Trump has shown he is prepared to follow through with threatened tariffs. There is no strong reason to believe this approach would change this time, so our base case is for the 10% tariff to be implemented on 1 September. We don't think a 10% tariff rate would be sufficient to send the US economy into recession, but it would represent an economic drag, as well as further harming business confidence.

3. Risk case (30% prob.)

• The risk case is a tariff rate of 25% on all US imports from China, which would significantly increase the risks to the global business cycle. In this scenario we estimate a 50% chance of a US recession in 2020. Our view is that the Trump administration will want to avoid a US recession ahead of the US presidential election, and China’s response to rising tariffs to date has been measured. But if China were to lose patience and use more of the policy responses at its disposal – like much sharper CNY depreciation (towards 7.3-7.5), introducing a broad “unreliable entity list”, restricting exports of rare earth metals, or selling off US Treasury holdings – this would increase the risk that the US moves to 25% tariffs.

The next question is how the Fed will react at its September meeting if our base case proves correct. We estimate it would take 50bps of cuts by the end of the year to be sufficient to offset the impact of the tariffs in the markets' eyes. If the Fed were just to deliver one more 25bps cut, we believe markets would be disappointed.

Either way, it looks likely we're heading into an environment of lower growth and lower interest rates.

As such, we put greater focus on balancing risks and on "carry trades" that can help boost portfolio income. Our overweight to long-duration Treasuries has helped to dampen portfolio volatility, and we expect it to continue to do so, but further upside will be limited unless there are concrete signs of an impending recession, which still looks unlikely. In our FX strategy, we overweight a basket of higher-yielding emerging market currencies against a basket of lower-yielding currencies.

We also remain overweight equities, with a regionally selective approach, overweighting US, Japanese, and emerging market stocks but underweighting international developed stocks (especially the Eurozone). This positioning reflects the differing potential impact of new tariffs on corporate earnings. For example, S&P 500 earnings per share growth should be about 1% this year and 7% next year, while we expect Eurozone earnings to be flat in 2019, with risks to the downside. Eurozone equities’ high exposure to global trade means the indirect impact of the 10% tariff could be significant, and if there is no economic recovery in the Eurozone in the second half, earnings growth could be reduced by three to five percentage points.

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