The divergence between positive economic data and negative policy news is rarely as wide. While the global economy continues to grow at a healthy pace, many of the policy risks we’ve been highlighting have either increased or materialised.
It is tempting to focus on the escalation of trade war rhetoric between the US and China. However, this would ignore important positive developments in the global economy. Indeed, the macro picture in advanced economies has been strong enough to keep central banks on course to normalise monetary policy. The Fed raised its policy rate by another quarter of a percentage point. The ECB has yet to firmly signal its commitment to extending its asset purchases beyond September. The Bank of Japan altered the language of its statements, raising the possibility of a shift in monetary policy before inflation reaches 2%.
Despite positive macroeconomic data, equity performance has been lacklustre and volatility increased. In our view, there are two macro reasons behind this development.
First, while the earnings season has been positive, with the majority of companies in all sectors exceeding expectations, company guidance has generally pointed to a somewhat more moderate outlook. Second, although growth has been led by rising investment in advanced economies, rising inventories have been the second largest contributor to growth. High inventories can presage slower growth, if consumption does not pick up sufficiently. In sum, the outlook is positive but moderating. This, in turn, acts to magnify the impact of both policy and political risks.
There are two important sources of policy risks. The first is the escalation of trade frictions. The second is the impact of rising policy interest rates at a time when the global stock of debt is at record levels.
The trade measures announced by the Trump administration can be interpreted in a number of ways. A turn towards a more protectionist trade stance is a clear objective of the Administration. What is less clear are the precise outcomes that the Administration is trying to achieve.
The steel and aluminium tariffs were promptly followed by exemptions for the largest exporters of steel to the US, to give sufficient time for negotiations to take place. This is an effective recognition of the complexity of imposing tariffs in a world where production chains are globally integrated, and the potential risk to key US exports if countervailing measures are imposed.
The tariffs and counter-tariffs announced by the US and China in other areas appear small at first glance, impacting 0.25% and 0.5% of GDP respectively. However, these are more complex and problematic to resolve. While the US targeted some key Chinese exports, some tariffs target goods that China does not currently export to the US. What could be the purpose of such an announcement then? It appears that the Administration has narrowed the tariffs against higher value-added goods (including technology) that China aspires to export under its government’s development strategy.
This creates a new dynamic in trade negotiations. The standard argument that China is dumping goods does not apply. The imposition of these tariffs suggests that China’s development plans are skewed in a way that would make future exports unfair. This adds a level of complexity to the negotiations that goes beyond simple calculations of implicit subsidies today, to raising structural questions regarding the economy as a whole.
This type of trade dispute will not be simple to resolve. Heightened uncertainty may linger for some time. It is also likely to have spill-overs on other areas, such as cross-border merger and acquisition activity. We have already seen some high-profile mergers delayed due to bottlenecks in regulatory approval. For example, of $34 billion in bids by Chinese companies to acquire US semi-conductor companies, only $4 billion have been approved. Additionally, a cross-Atlantic merger has been delayed by Chinese regulators.
The second source of risk to the market emanates from rising interest rates at a time when debt levels are already high. Rising US rates raises the cost of refinancing debt at a time when the fiscal deficit is increasing due to tax reform. In this environment, small surprises on inflation may have an outsized impact on fixed income assets denominated in US dollar, whether these are in the US or elsewhere, including emerging markets.
Against this background, we maintain the positioning of our portfolios to be underweight in US equities, and overweight Europe and Japan. We recognise that Japanese and European markets are sensitive to global trade developments. However, valuations in both markets (especially relative to fixed income assets) remain far more compelling than in the US. In fixed income, we remain underweight all but High Yield bonds, where the relatively short duration of the market reduces the likelihood of negative returns in a rising interest rate environment.
