Making Sense of a Roller Coaster Market

Over the last two weeks, investors have been on a disorientating roller coaster ride:

• 14 Aug 2019: S&P 500 falls 2.9% - Recession fear rises as 2Y-10Y yield curve inverts for the first time in 12 years.
• 16 to 19 Aug 2019: S&P 500 rallies 2.7% - Relief as White House confirms trade talks back on in September.
• 23 Aug 2019: S&P 500 falls 2.6% - Trade fear spikes as Trump dramatically hikes tariffs in response to Chinese retaliatory duties.
• 26 to 29 Aug 2019: S&P rallies 2.7% - Relief as Trump says China called US officials to initiate trade talks. China then says it will not retaliate to latest US tariffs. 

Through these twists and turns, our view is that the broad fundamentals of the market were mostly unchanged throughout.

1. Businesses need stability and predictability to make decisions, and this environment is anything but. If the ongoing decline in business confidence is severe enough, it would eventually spill over to the consumer side of the economy and labor markets. This drives up the risk of a recession.
2. The path to a Sino-US trade deal remains tenuous at best. Chinese policy makers are unwilling to concede on redlines, such as industrial policy, market access and enforcement mechanisms, which form core US requirements. It also sees the removal of all trade war tariffs as a precondition for a deal - a high bar. On the other hand, Trump cannot agree to a weak deal that does not contain significant concessions from the Chinese. Doing so will trigger a political backlash and impact his 2020 re-election chances.
3. Trade-related uncertainties, uncompelling valuations and rising recession risks all point to a challenging market outlook. A defensive lean in asset allocation is sensible against this backdrop. In particular, equities in Asia excluding Japan stand at the front line of the trade war and continue to face headwinds from persistent dollar strength.

That said, while recession risk is significant and rising, we believe it is premature to forecast a global recession over the next 12 months as a baseline scenario, and it is more likely than not that the economy will bend and not break over this period.

Granted, a bad mix of trade policy uncertainties, rising tariffs and supply-chain disruptions easily suggests more downside for corporate confidence, but the global monetary policy easing cycle led by the Fed will have an offsetting and supportive effect. Sentiment in the service sector and consumer confidence, which has been more resilient, will also gain support from lower interest rates.

If we benchmark the risks today against history, past recession threats in 1995, 1998, 2011/12 and 2015/6 were all successfully resolved by moderate central bank action. In 1998, the Fed conducted a set of interest rate cuts adding up to 75 basis points against a backdrop of palpable fear, triggered by a rolling series of toxic events: the Asian Financial Crisis, the Russian default crisis and the collapse of LTCM. This was enough to avert a recession.

One issue, however, is that the economic impact of a modern trade war is not fully understood, which means that the risks of policy missteps are significant. Not since the Smoot-Hawley Tariff Act in the 1930s have we seen trade conflict of similar global magnitude, and as the Fed Chairman Jerome Powell said in his speech at Jackson Hole: there are “no recent precedents to guide any policy response to the current situation.”

Given that we are in the mature stages of this economic expansion, the distribution of potential outcomes has a longer tail towards the downside. Even if a recession is not inked in for now, investors should not be surprised by more of the same harrowing ride ahead.