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Trade War Tests Base Case for 2019

Published September 20, 2018

As the trade conflict between China and the US escalates, we test our base case for continued economic growth in 2018/2019 and examine the potential catalysts for change in equity and fixed income markets over the next 12 to 18 months. While the latest round of tariffs ramps up the political tension and affects a broader range of goods, the impact on GDP could be as little as 0.2-0.3% for China (significant but not catastrophic) and even less for the US.[1] More worrying is the likelihood that the retaliation could continue, though the outcome of the US mid-term elections may alter the direction of future negotiations.

If tensions ease later this year, we see no immediate reason for a change in market direction before 2020, while market dispersions are creating opportunities for our active equity teams. However, in a world of tightening monetary policy, heightened geopolitical tensions and diverging regional growth, it makes sense for investors to ensure that their portfolios are positioned for the next stage of the cycle.

Base Case: Strong Economic Growth Underpins Markets

Despite recent jitters, especially in emerging markets with large amounts of US dollar-denominated debt, strong earnings figures in the US and reasonable earnings growth elsewhere have continued to drive global equity markets. We expect global GDP growth to continue on its current path towards 4% this year, though given the potential for weakness in China, Japan and Europe and trade-related costs,that estimate could fall slightly. Following last year’s synchronized global recovery we are seeing greater divergence between major economies.

The US continues to power ahead, thanks to indigenous momentum from cheaper energy and the temporary stimulus provided by President Trump’s tax cuts. In particular, the ability to expense 100% of investment is showing up in order figures. Such a late-cycle sugar rush could push the US to grow above 3% in 2018 and between 2.5% and 3% in 2019. Europe and Japan, meanwhile, continue to disappoint after stronger growth last year, while China is showing signs of a more significant slowdown, accelerated by trade issues.

Chinese policymakers are already responding by cutting reserve requirement ratios (providing additional liquidity to the market) and slowing down the structural reforms aimed at reducing productive capacity and debt in state-owned enterprises. The secondary effects of slower economic activity in China are being felt in oil and base metal prices, which have stopped rising for the moment, though tighter supply dynamics could push prices higher into 2019.

Potential Risks to Our Outlook

Trade: Trade wars remain the most immediate risk to our base case, particularly between the US and China. If the US-China situation continues to escalate, leading to tariffs between 25% and 30% on all trade between the two countries, and perhaps some tit-for-tat tariffs as high as 10% on European cars, we could see some real damage done to the global economy.

As China imports less from the US than vice versa, the Chinese are likely to respond with other measures such as fees, quotas, restrictions and inspections, all designed to deter foreign trade. According to UBS, if this type of scenario ensues, we could see a whole percentage point knocked off global growth, bringing a near 4% rise down to 3%, and turning a good number into an anaemic one. It would also probably reduce both China’s and the US’s GDP growth by 2 percentage points each. Markets are not currently pricing in such a scenario and could therefore react sharply to any signs of major trade dislocation, if as adverse effects on supply chains, confidence and jobs begin to emerge.

Such an outcome could have a systemic impact on businesses, consumer sentiment and investment, resulting in damage to productivity and a spike in inflation. At present, we believe the probability that this will happen is low. China aside, trade talks between the US and Europe have been productive, while the US seems to be reaching a deal with Mexico on NAFTA, which appears to have only marginally changed the existing agreement; an agreement with Canada, once reached, may not change much in real terms either. Nonetheless, this remains a key risk to monitor.


Tighter Monetary Policy: A potentially more important long-term risk is the process of monetary tightening. In addition to rising rates in the US, the UK and Canada, the European Central Bank is likely to bring its quantitative easing program to an end in the final quarter of 2018. While the Bank of Japan shows no signs of ending its program, observers believe it could consider reducing it if inflation holds up in 2019. When the cost of borrowing rises, it can hamper corporate growth, as cashflows are discounted forward at higher rates, and hurt highly leveraged companies. This is particularly a concern with regard to emerging markets and other regions outside the US, which hold a considerable amount of USD-denominated debt (Figure 1).

There is around $11 trillion of outstanding USD debt held outside the US, of which $3.5 trillion is held by emerging markets. Since 2010, USD debt held by EMs has gone up substantially, with China in particular borrowing twice as much by 2018.[2] As long as a country maintains a credible policy in dealing with its debt, it can continue to borrow. However, with more countries exposed to higher levels of hard currency debt, markets are more sensitive to the opportunity for less stable economies to miss or delay debt payments as the dollar strengthens and US interest rates rise. Much will depend on whether sovereigns or corporates have borrowed at fixed or floating rates and when they need to refinance. Even the US, which can theoretically just print more dollars to pay its debts, has investors worried about its prospective fiscal situation and the prospect of higher volatility as interest rates rise.

While sovereign debt growth is potentially a source of concern, corporate debt has seen its own trends. Credit markets have grown significantly in the last ten years but are unlikely to be the source of the next market rollover, in our view. Over-indebted companies in the energy sector have already been flushed out, and while companies are borrowing more, especially IT giants such as Apple and Microsoft which previously borrowed little, they are using the cash to consolidate their industries via M&A, to refinance or buy back shares. They are not using debt to create the sort of overcapacity that typically precedes a downturn. By contrast, we have concerns about the leveraged loan market. It is now primarily run by non-bank entities and has sold a considerable amount of debt with relatively weak covenants to institutional and retail buyers in the past five years.

We are also watching exchange rates in EMs which could affect domestic holdings in our fundamental equity funds. China, for example, has seen its currency decline against the dollar. This has less to do with direct manipulation than the fact that China has recently been running a weaker current account, as it imports more than it exports, and shoring up financial institutions and the economy against the impact of trade tensions (Figure 2). It is also a function of more money leaving the country, as Chinese asset owners seek to diversify more globally, according to data from the World Bank.

 

Correlated Assets and Holdings: Finally, the Bank of International Settlements has also identified late-cycle risks of high correlations between asset classes and among asset managers. The latter can amplify volatility when they decrease exposures simultaneously, helping to make financial factors a more important trigger for business cycles. This is especially the case for the big technology stocks, which have been identified by the Fed as the main drivers of recent US growth and a potential risk to the broader market if their earnings drop suddenly. Thanks to increased capital regulation, investments banks have less capacity to be market makers so when there is a crisis, such as in Turkey, a lack of buyers can exacerbate price drops. It is therefore prudent, in our view, for investors to diversify their portfolios and review manager exposure where appropriate to ensure their underlying holdings are sufficiently differentiated.

Opportunities for Investors

Despite the trade war noise, we continue to see plenty of opportunities for investors from a growth and value perspective as markets diverge. Our focus is on finding stocks that are less likely to be affected by changes in the business cycle. Outside the US where earnings multiples are at the top of their historical range, the value opportunity set has increased, especially in EM and in Europe. We have already seen a bounce back in those markets considered most vulnerable to trade tariffs, after those actually imposed were not as dire as initially feared. Nonetheless, a wall of worry remains priced into areas such as Europe, EM and China, so there may be significant upside potential if the worst of those risks does not transpire.

From a thematic perspective, we have been exploring growth opportunities in those industries adopting Artificial Intelligence (AI), especially banking, to drive their bottom line. In our view, AI is going to become an ever more dominant part of the economy and investors should be considering which companies will be the winners and losers from the disruption it will bring. Indeed, intangible assets such as software have already overtaken industrial equipment as the main recipient of investment in the US (Figure 3).

1 Source: SSGA estimates

2 Source: Bank of International Settlements, end 2010 to end March 2018

 

Conclusion

The current cycle is now very long in the tooth and US exceptionalism is likely to diminish in 2019 as the late cycle boost plays out. That said, we see no immediate catalysts for equity and credit markets to go into sharp reverse other than the potential fallout from trade wars if they escalate further. Geopolitics aside, market consensus is looking ahead to 2020 as the timing for the end of the cycle, meaning we could see more volatility in 2019. However, the Fed has indicated it is likely to be very cautious on raising rates in this post-crisis environment, so unless trade wars materially affect inflation, quantitative tightening may happen more slowly than many expect.

Disclosures

The views expressed in this material are the views of Gaurav Mallik through the period ended September 6, 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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