US-China trade dispute intensifies

What happened?

A further deterioration in US-China trade relations pushed the S&P 500 3% lower, the Euro Stoxx 50 1.7% lower, and the Hang Seng down 3.1%, taking the losses since President Trump's threat on Thursday last week to impose further tariffs on Chinese imports to 4.6%, 4.9%, and 6.2%, respectively. In addition, global bond yields continued to fall, with the 10-year US Treasury yield down another 10bps to 1.74% and the German 10-year Bund yield falling to another record low of –0.52%. US President Donald Trump today accused China of "currency manipulation," after the authorities allowed the yuan to fall to its lowest level in over a decade against the US dollar, with USDCNY breaching 7. There were also reports that China had instructed state-owned enterprises to suspend the purchase of US agricultural goods, such as soybeans.

These developments increase the risk that the trade truce struck between the US and China at the G20 summit on 29 June will come to an end, leading to a return to tit-for-tat retaliation. This would present a significant headwind for global growth, corporate profits, and markets. While recession risk has increased since the Federal Reserve cut interest rates last week, and markets are adjusting, a recession is not in our base case, and we believe that negotiators on both sides still have strong incentives to find a resolution that limits the economic damage.

What comes next?

The immediate concern for markets is to find out if the next few days continue to see the conflict evolve beyond today's "currency manipulator" comments. Then, over the coming weeks, there are essentially three potential scenarios.

1. The new 10% tariff comes into effect: This round of tariffs would be more economically challenging than prior hikes. The remaining USD 300bn of Chinese products not currently covered by punitive tariffs are mostly consumer goods including smartphones, computers, and textiles. Compared to the imports affected by prior rounds of tariffs, China accounts for a larger share of global production of these goods, making it harder for the US to find substitutes from other countries. Running out of US imports to tax, China may respond with non-tariff measures such has slowing down the approvals of US corporate investments or hindering the operations of US multinationals in China. China could also further curb purchases of agricultural goods, possibly as a means of undermining President Trump's support base among rural voters ahead of the November 2020 presidential election. But while a 10% tariff rate would represent an economic drag, as well as further harming business confidence, we believe both economies could still avoid recession.

2. A return to the truce: The US and China reach an agreement to avert the implementation of the new tariff. The US president has left some time to maneuver, since tariffs will not go into effect for several weeks. China may seek to offer renewed assurances to step up the purchase of US agricultural goods, an issue over which President Trump has frequently expressed concern. Chinese policymakers have already sought to underline that they would not to seek to drive the currency lower to gain a competitive advantage. People's Bank of China Governor Yi Gang said that the yuan would "remain a strong currency in spite of recent fluctuations."

3. The tariff rate rises to 25% on all Chinese imports: In this scenario, we would see a meaningful probability of a US recession, and for Chinese growth to drop below 6%. All of the effects of the 10% tariff would still apply, but the impact would be significantly greater. Tariffs have nonlinear impacts because, while we believe companies can absorb 10% tariffs in their margins and/or have some scope to increase prices, 25% tariffs would lead to some activity becoming deeply unprofitable, and supply chains would need restructuring. Downside for US markets could be in excess of 10–15%, and 15–20% for Chinese equities. We would expect the Japanese yen, which has rallied 2.5% since 31 July, to rally further in this scenario, acting as a hedge in a portfolio context.

What does this mean for investors?

?The past few days have seen global stock markets adjust downward and we believe they are broadly now priced for implementation of the 10% tariff. We think a move to impose a 25% tariff on the full range of Chinese imports remains unlikely, since President Trump may calculate that this would significantly raise the risk of a meaningful US slowdown, which could impede his reelection chances in 2020. Meanwhile, a retraction of the threat of 10% tariffs—or indications from the Federal Reserve that further easing is imminent—could help take stocks back to where we were last week.

Markets are still in flux—we don't know what the next Fed speaker might say, or the content of the next tweet from President Trump—and economic and earnings dynamism is relatively muted, but with global central banks already signaling their willingness to ease, we are not expecting to see a repeat of the sell-off in the fourth quarter of last year.

For now, we are inclined to see this pullback as a temporary pocket of volatility, rather than the beginning of a bear market. Such "bull market corrections" are a common feature of market cycles; since 1900, the US equity market has seen a peak-to-trough decline of 5% about three times per year, with 10% losses occurring about once per year and 15% sell-offs occurring every other year.

We are not recommending any changes to our tactical asset allocation at this time, but we will be watching developments closely for opportunities. In the meantime, there are several steps that investors can take in response to the market uncertainty:

1. Rebalance your portfolio. Rebalancing can help investors keep their portfolios from drifting too far from their target allocations. Investors should look at their portfolios following the drop in equity markets and rebalance back up to their desired target asset allocation. For example, 20+ year Treasuries have rallied about 4.7% since the end of July, and 20–30-year STRIPS have gained 6.3%. While we continue to recommend an overweight allocation to long-duration Treasuries, this may be a good opportunity to lock in some gains in order to replenish allocations to US, Japanese, and emerging market stocks, where we also recommend an overweight.

2. Look for carry. With central bank policy already loosening, and likely to continue in that direction if trade tensions rise further, we think carry is likely to be in strong demand. In our FX strategy, we overweight a basket of higher-yielding emerging market currencies (Indonesian rupiah, Indian rupee, South African rand) against a basket of lower-yielding currencies (Australian, New Zealand, and Taiwan dollars). We think our overweight basket should benefit from a favorable carry environment, as well as steady global and emerging market economic activity. We also see long-term value in US dollar-denominated emerging market sovereign bonds, which have spreads of around 350bps over US Treasuries.

3. Focus on quality. In difficult markets, a quality tilt can often add value to equity portfolios. As we noted in our recent Dividend Ruler update, our model portfolios have performed well amid rising trade tensions, and continue to exhibit lower downside capture than their benchmarks.

4. Don't fight the Fed. Markets are underpricing inflation, in our view, especially with the Fed committed to achieving that part of its dual mandate, so we recommend an overweight to Treasury Inflation-Protected Securities (TIPS) versus US government bonds.

5. Seek domestic exposure in Asia. Multinational firms in Asia are likely to come under heightened pressure. With trade uncertainty persisting, we would expect firms with higher domestic exposure to outperform.

For more information on how to manage an uncertain short-term environment while continuing to invest for long-term goals, please see our Plan. Protect. Grow. report.

US version of the CIO Alert published on August 5 by Mark Haefele, Global Chief Investment Officer.

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