Tensions between the US and its trading partners have contributed to a rise in market volatility this year. A recent escalation in rhetoric by US President Trump and action on tariffs have raised investor concerns over the global economic outlook. But are these fears justified and at what stage should we really be worried?
If we look at the global economic impact of the US fully implementing its threatened tariffs on Chinese imports, then our economic modelling suggests that the global impact is likely to be limited and manageable.
If we look at the global economic impact of the US fully implementing its threatened tariffs on Chinese imports, then our economic modelling suggests that the global impact is likely to be limited and manageable. We must keep in mind that despite the tariffs being bilateral, other economies could be impacted, for example Japan, Taiwan and South Korea, reflecting their role in China's supply chain. Overall though, it is a deterioration that the global economy should be able to weather, particularly given that most large economies are currently growing at above-trend levels.
Given this growth backdrop and current valuations, we believe that maintaining a pro-risk stance in our multi asset portfolios makes sense as long as the dispute remains largely bilateral (between the US and China) and does not extend beyond tariffs on USD450 billon of US imports from China. Nonetheless, we remain mindful of the possible impact on sentiment and cross-asset correlations.
However, our view could be challenged if the US decides to push ahead with its threat to impose blanket 20% auto tariffs. This is a more worrying prospect as more economies would be affected. That said, the situation may not significantly escalate if the US economy starts to show any signs of being adversely affected by recent measures.
We believe that maintaining a pro-risk stance in our multi asset portfolios makes sense as long as the dispute remains largely bilateral (between the US and China) and does not extend beyond tariffs on USD450 billon of US imports from China.
In the longer term, there is scope for the global economy to counter a potentially increasingly isolationist US economy with its own push for deeper integration. Indeed, the vast majority of economies – including China – remain tied to the rules-based multilateral trading system. Recent progress with the Trans-Pacific Partnership (TPP) and the Regional Comprehensive Economic Partnership (RCEP) in Asia, as well as the ongoing Belt and Road Initiative, are examples of deeper ties in a region that accounts for an ever-larger share of world GDP and trade flows.
A pro-risk investment stance
Notwithstanding the recent investor nervousness over the trade tensions, the global economic picture remains good. Economic growth is robust, albeit more differentiated across economies this year than last. Growth has slowed in Europe and Japan, and inflation pressures have begun to build in the US, prompting a rise in bond yields, but the corporate sector is in good shape, globally, and the risk of recession remains low. Given current valuations, we still believe that equities represent the best way to participate in underlying economic growth. We therefore maintain our moderately pro-risk positions in multi-asset portfolios, with a preference for global equities and emerging markets as we think they offer the best risk-adjusted prospective returns.
The inflation factor and fixed income
Investor perceptions of inflation risk have moved quite a lot since the start of the year. Even though we have seen a pick-up in cyclical inflation (in the US), the longer-term structural environment points to a low inflation global economy. In developed market government bonds, the reward (risk premium) for taking duration risk remains negative in many of the major developed markets, such as German Bunds, UK Gilts and Japanese government bonds. We therefore remain cautious on developed market government bonds generally, given that they continue to offer low sustainable returns and face an unfavourable environment, with building cyclical inflation and central bank policy tightening.
That said, US Treasury bonds are in a bit of a different place, over the short term at least. After a big re-pricing of interest rate expectations over the last twelve months, the risk premium in US Treasuries is now positive. The short end of the curve yields more than the dividend yield on US equities, which has not happened in the last 10 years. The risk reward balance is certainly more attractive than previously, particularly at the short end of the yield curve.
In corporate bond markets, credit spreads are offering slightly better value than earlier in the year, but still offer only a slim margin of safety against negative shocks, so we maintain an underweight position in our multi-asset portfolios. Whilst credit quality remains fairly stable, high leverage levels indicate vulnerabilities in some sectors.
Overall, while investors continue to digest the latest moves on trade protectionism, inflation and interest rates, volatility in markets is likely to remain.
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