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Cautiously constructive despite trade war risks


As the rhetoric swells again in the arm wrestling between the US and China over trade, and arguably global power, investors should keep an open mind about opportunities to add to market risk at better valuations.

  • Trade war risks are back in focus – Investors are grappling with another wave of Sino-US trade war angst and markets have suffered from renewed volatility.
  • De-globalisation is at the heart of the trade war – We have long argued that there is more than trade to the Sino-US tensions, and that de-globalisation trends are a medium to long-term theme. As such, we are not surprised to see another flare-up in tensions in the short term.
  • ‘Fragile goldilocks’: is a slowdown becoming a bigger risk? – While certainly a risk worth monitoring, our slowdown scenario already incorporated Sino-US tensions. If anything, given the goldilocks backdrop, recent tensions have provided us with attractive entry points to add market risk in developed markets.
  • Fundamentals make the difference – Not all assets/economies are equal and macroeconomic fundamentals are making the difference. We note the underperformance of emerging market(EM)/Chinese assets, where economic prospects are more challenged by trade war risk. Developed market, and specifically US domestic fundamentals remain solid.


Fluid times: trade war risk is back

Markets remain fluid and investors have shifted focus several times over recent months. After fearing a recession during the final quarter of 2018 when macroeconomic data weakened considerably, markets were euphoric in the wake of the Federal Reserve’s (the Fed) pivot to neutrality on monetary policy. This was reinforced by goldilocks conditions in until worries about a Sino-US trade war resurfaced in recent weeks.

With the news revolving around import tariff increases and US bans on major Chinese firms, the recent wave of investor angst is understandable. However, as we outline below, it is not a game changer for our outlook as we had already factored in de-globalisation risk as a medium to long-term theme.

As we have explored in recent publications, the economic and policy backdrop still endorse a goldilocks environment. As Exhibit 1 shows, robust but more moderate growth coupled with low inflation means the Fed’s “policy put” is credible, endorsed by the recently published Federal Open Market Committee minutes which confirm policymakers are focusing on (low) inflation.


Exhibit 1: Moderate US GDP growth and low inflation – no pressure on the Fed to change policy; one consequence is a ‘goldilocks’ environment


Source: Bloomberg and BNPP AM, as of 31/05/2019

‘Fragile goldilocks’: is the slowdown scenario becoming a bigger risk?

That said, we always characterised the current goldilocks environment as fragile – i.e. easily destabilised.

Regular readers will be familiar with our scenario matrix shown again in Exhibit 2. In our view, the threat to goldilocks – and hence the current sweet spot for markets – is twofold:

  1. a material/sustained increase in inflation could force the Fed to tighten policy rates again
  2. a slowdown in activity/recession, where even renewed Fed easing is initially insufficiently stimulative.

In light of the recent bout of trade war news, the key question is whether the risk/probability of the synchronised slowdown scenario has increased?

Exhibit 2: A material escalation in US-China tensions creates risks of a global economic slowdown


Source: Bloomberg and BNPP AM, as of 31/05/2019

De-globalisation at the heart of the trade war

In our view de-globalisation trends are at the heart of the trade war between the US and China. There are issues extending way beyond trade in this struggle for global power.

Indeed, as the recent US ban on a large Chinese telecommunication supplier has shown, IT dominance, strategic infrastructure, espionage, cyber security and intellectual property rights are equally important aspects of the Sino-US tensions.

As we have argued before, the medium to long-term trend is for a reversal of the globalisation forces prevalent in recent decades. But equally, there are shorter-term cyclical gyrations around this de-globalisation trend. At times tensions will ease (as during the first quarter of 2019), and then deteriorate again (as in 2018 and second quarter 2019).

As such, the recent increase in tensions between the US and China comes as no surprise to us. If anything it has created an entry point to buy developed market equities which we consider to be less vulnerable to trade war risk than some other assets.

Overall, we hold a cautiously constructive view on US-China trade tensions. Our base case is that the renewed trade tensions will eventually lead to a trade deal. We see three broad scenarios in the short term to Sino-US tensions:

  1. a rapid resolution of trade tensions with a new deal agreed in matter of days (very low probability)
  2. a slow resolution with prolonged/tense discussions ending in a trade deal in weeks/months to come (medium probability)
  3. an escalation of tension and no eventual trade deal (low probability).

The key signs to follow for de-escalation are: i) a reversal of trade tariffs and ii) progress in trade discussions ahead of the G20 Meetings in Japan on 28-29 June, where President Trump is willing to meet President Xi.

For sure, the process will be tense and may last for weeks/months, but it may open opportunities to add to market risk at better valuations – such as the recent equity dip which we bought into.

Of course we cannot be 100% sure, and with the situation rather binary, the risk of an escalation remains and we hold several portfolio diversifiers for such a risk event, (see detail on our current asset allocation below).

Asset allocation

  • Buying on the dip: overweight developed market equities – We took advantage of the recent equity market correction to add market risk via US and EMU equities.
  • Overweight carry assets – In our view the goldilocks environment is conducive to carry assets. Consequently we are overweight EM hard currency debt (high carry, USD exposure), with REITS also on our radar as an asset we would potentially buy on dips.
  • Building robust portfolios – Whilst we hold a cautiously constructive view on the resolution of US-China trade tensions, we also hold diversifying trades to protect portfolios. An overweight position in 5-year US bonds versus 5-year German sovereign debt, an overweight in USD versus a basket of Asian currencies and a relative value position CAC/DAX in equities should help diversify trade war risk.


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