As investors weigh up the forces that could extend or curtail the current cycle, the risk of an all-out trade war is the clear and present danger weighing most heavily on market sentiment. Protectionism was the biggest downside risk we called going into 2018, and remains the biggest risk to our core investment views for the remainder of the year. Here are our views on the most recent market turbulence.
Clearly we’ve moved beyond the war of words as the first set of US tariffs on roughly $34 billion worth of Chinese imports is scheduled to take effect on July 6th. But investors can be forgiven for feeling whiplashed by the differing signals coming out of the Trump administration on trade.
There is palpable tension between Treasury Secretary Steve Mnuchin, who has indicated he would like to see more nuanced trade negotiations, and trade hardliners like Peter Navarro, Trump’s Director of Trade and Industrial Policy. But it is telling that even Navarro issued a reassuring statement when the markets sold off on Monday over concerns that tech companies might be hurt by limits on exports of high-tech products to China and investments in technology firms by companies with substantial Chinese ownership. Ahead of the November mid-terms, we expect Trump will be watching the often contradictory signals from both his base and the capital markets equally closely, adjusting trade moves accordingly. The question is whether he can adequately calibrate reaction to those conflicting signals or if the tit-for-tat spirals out of control.
We know China cannot match US tariffs dollar-for-dollar in retaliation simply because it imports far less from the US ($130bn) than the US does from China ($433bn). But China has other powerful levers, including making it more difficult for US companies to do business in China, delaying licenses or holding up M&A. It can also potentially persuade billions of its consumers to turn their backs on US goods. On the other hand, our view is that currency depreciation or dumping US Treasuries is far down the list of China’s preferred options, only because these moves will not help China in the long term. And for a country whose official view is that it is still “too early to tell” what the French Revolution means, China is nothing if not long-term oriented.
Our bottom line is that trade wars have no winners, and that the US-China relationship is simply too big to fail. Now that Trump has turned America First into America Alone, he has missed a valuable opportunity to join ranks with the EU and Japan to raise legitimate concerns over China’s trade practices. The biggest loser at the moment is market sentiment, and we expect markets to remain quite volatile as the tariffs are enacted. That negative sentiment is weighing on emerging markets, especially those that are part of the larger global supply chains that could be hit quite hard by protectionism. At the same time, we are seeing a flight to quality, boosting havens like US Treasuries, the dollar and the yen.
The Age of China
Notwithstanding the current trade battle and the fall-out for Chinese equities, we believe China’s long-term growth story remains intact. China’s leaders still indicate they can manage a necessary and orderly slowdown in growth, which is more of a problem for the rest of the world than for China itself. Credit expansion is still slowing, which might lead to some defaults and volatility in the short term, but we believe China can manage through this. Meanwhile, our Chinese equities teams are using the “guilt by association” sell-off in emerging markets to find attractive buying opportunities in Chinese stocks. We are focused on overseas equities rather than local A-shares because of sector and valuation benefits. Our main investment theme continues to be the power of the Chinese consumer and our portfolio is focused on companies tied to domestic consumption. China has just enacted the biggest overhaul to its tax system in two decades. We think the move to raise the personal income tax threshold will provide a big boost to domestic consumption as individuals see their purchasing power increase.
What About Emerging Markets?
Emerging markets have been buffeted by a combination of trade tensions, a stronger US dollar, higher US Treasury yields as well as idiosyncratic problems in countries like Turkey, Argentina and Brazil. Nonetheless, across the EM universe, economic fundamentals remain broadly supportive, inflation relatively under control and currencies undervalued in aggregate. On the equity side, we have reduced our exposure somewhat but remain cautiously overweight and ready to capitalize on opportunities created by short-term volatility. We also still find value in local currency debt. According to our measures of fair value, EM currencies in aggregate are 5-6% undervalued against the dollar. It is this relative value opportunity that underpins our positive view on local currency EMD.
Further Dollar Strength and Cyclical Peak in US Yields
With monetary policy and growth prospects diverging globally as downside risks around protectionism and the Eurozone’s future increase, we expect to see continued dollar strength for the remainder of the year. And contrary to others, we believe that as long as global growth remains relatively strong overall and inflation contained, 3% likely represents a cyclical peak for the US 10-year Treasury.
As we head into the second half of the year, “build the wall” is morphing into a wall of worry for markets. This week sees a key European summit in Brussels, with nothing less than the future of the European Union at stake, as nativist forces throughout the continent mount existential challenges. Choppy markets are here to stay. Our view? Stay invested and focus on those managers who can distinguish between “good” and “bad” volatility. Look for buying opportunities when the inevitable pullbacks occur. Heavy weather is coming, so review portfolio defenses in the form of hedging, greater diversification and uncorrelated assets.
The views expressed in this material are the views of Lori Heinel through the period ended (06/27/2018) and are subject to change based on market and other conditions. This document contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected.
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