Trade tensions: What's priced in?

Recently, we chose to use July's strong equity market to reduce our overweight in global equities. While we expect, when the final numbers are in, for this to be a strong quarter for corporate earnings growth, we have recently had more evidence that the trade conflict is escalating rather than deescalating. While geopolitical factors rarely move markets over the medium term, we note that this escalation comes at a time when we expect global GDP growth to slow. In the second half of the year, these factors and others make us believe the market may not be pricing in several increased risks:

No art of the deal.

While it’s tempting to view the Trump administration’s new 25% tariff threat as a negotiating chip, with tariffs already in place and more scheduled to be enacted, there is a possibility the trade conflict will extend beyond the mid-term elections.

Second order effects.

Markets do not appear to be pricing in the possibility of larger second-order impacts, such as supply chain disruptions, reduced hiring, lower investment, or a further escalation in the conflict.

Non-tariff retaliation.

China may look to alternative non-tariff measures to retaliate. Besides overt moves like weakening the currency or selling US Treasuries, Beijing could slow the delivery of key components to the US or impose additional bureaucracy on US companies.

While the US market has taken much of the tariff measures to date in stride, Chinese stocks have not reacted as calmly. The MSCI China Index is down 6% since the beginning of July. There are a variety of factors that have impacted Chinese equities. In addition to the tariff dispute, the Chinese economy has been slowing. Yet, going forward, we believe that there are reasons to be more positive on Chinese equities:

Policy is supportive.

China’s mid-year Politburo meeting last week reiterated a broader shift towards easier policy, including adjustments to the pace and scale of deleveraging, more “ample” liquidity provision, and an increase in infrastructure spending with more proactive fiscal policy. It is very clear that the central government wants to ensure stable growth. Deleveraging will continue, but at a slower pace, and with the timing of relevant polices subject to the market environment.

Valuations appear attractive.

Although a further escalation in trade tensions that hurts Chinese equities in the short term can’t be ruled out, the market’s decline means it is now more attractively valued, in our view. The ratio of price to 12-month forward earnings for MSCI China has dropped to 11x, a level 15–20% lower than at the start of the year. And earnings growth still looks strong, tracking near 15% for full year 2018 on our estimates. From a broader Asia ex- Japan perspective, we believe the market has more than priced in the originally proposed 10% tariffs, but there would be some further downside if they were increased to 25%.

Trade tensions have been increasing, and we recently reduced the size of our overweight position in global equities.

In our global tactical asset allocation, we are now broadly neutral global risky assets, comprising small overweight positions in global equities and in emerging market sovereign debt, combined with an overweight to 10-year US Treasuries that could help provide protection against geopolitical shocks.

Bottom line

Trade tensions have been increasing, and we recently reduced the size of our overweight position in global equities. While geopolitical factors rarely move markets over the medium term, we note that this escalation comes at a time when we expect global GDP growth to slow. Markets may not be pricing in some increased risks.

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