Time for stock investors to prepare for a bumpier ride

The bounce in equity markets this year has taken some by surprise. But is this a rally that has further to run, or should investors use it an opportunity to steel their portfolios for a tougher second half of the year?

The answer lies in the trade war and US Federal Reserve, which were at the heart of December’s sell-off and the subsequent recovery so far this year. During the final quarter of 2018, it became clear that the trade war was becoming a drag on the global economy, hurting activity in Germany and China. At the same time, the Fed seemed breezily oblivious and intent on taking interest rates higher.

Investors have had reason to become less anxious on both fronts. Beijing and Washington have returned to the negotiating table in a bid to prevent the US from raising tariffs, starting in less than two weeks, from 10 per cent to 25 per cent on $200bn of Chinese imports.

The Fed’s rate setters, meanwhile, have changed their tone entirely. Having spent much of their October meeting debating whether interest rates should be pushed to levels that would be “restrictive” for a red-hot US economy, the same group now believes it can be “patient” in deciding its next move. The group no longer sees any clear need for higher rates in the near term, and has also reassessed the need to shrink the central bank’s holding of bonds.

The sharp shift from the Fed has been echoed by other central banks, including the European Central Bank and Bank of Japan. The “punch bowl” may not be whisked away as quickly as everyone was thinking just two months ago.

It is why equity and oil prices have been rising this year but bond yields have fallen.

Given valuations in most stock markets are no longer as screamingly cheap as they were at the start of January, further gains for equities will require at least one of two things. Trade negotiations need to proceed amicably towards a conclusion, and US inflation needs to remain subdued enough to stop the Fed from resuming rate rises.

The former outcome seems doubtful. Trade tensions may not boil over, but they seem likely to simmer. Indeed, the Trump administration’s concerns go beyond the issue of whether China’s tariffs or the country’s approach to intellectual property are fair. They extend to China’s industrial strategy. Both governments wish to dominate the fast growing global tech industry (in the case of the US, for security as much as economic reasons). The US is worried at the state-directed support China provides for its tech industries under the umbrella of the Made in China 2025 industrial strategy.

By contrast, China believes such support is needed to sustain the pivot in its economy from agriculture and low-end manufacturing to higher-value industries. There seems no common ground on this issue. Washington may also expand its focus to European car tariffs.

President Donald Trump’s “America First” agenda still has considerable public support and is likely to remain the backbone of his 2020 re-election campaign. It is another reason investors should be wary of expecting US-China tensions to suddenly evaporate.

Global capex is one casualty of the trade war — and that matters for the fate of the current global economic expansion. Within developed economies, corporate investment is now needed to lift productivity and extend the cycle. But measures of future capex intentions are falling rapidly, including in the US. An index of global capex intentions compiled by JPMorgan’s investment bank has turned down sharply in the past six months and is now pointing to an outright contraction in global capex spending this year.

If the lack of capex ultimately tightens the labour market, sending wage inflation higher, then the Fed could yet find itself having to raise interest rates again. The bumper quarterly earnings from Walmart this week offered signs that retail pricing power is returning.

While the Fed has implied it will be willing to tolerate a bit of inflation to show it has a symmetric approach to the 2 per cent level it targets, rising consumer prices and asset price inflation could raise questions about the credibility of the institution under a Trump administration that has a preference for low interest rates.

This year could well feel like a rerun of 2018, as early optimism peters out. Investors would be advised to take advantage of the bounce in equities to adjust portfolios towards a more defensive, globally diversified portfolio that favours value stocks. The bumps for equities have not finished.

Karen Ward is chief market strategist for Emea, JPMorgan Asset Management