Only nimble investors can tackle the US-China trade war threat

The big question for markets in 2019 is where the US administration is heading on trade policy. After all, it is this presidency’s more hostile approach to global trade that was behind much of the disappointment across economies and asset markets in 2018.

It was not inflation that derailed the expansion. The Federal Reserve has been slowly raising rates and the European Central Bank has just ended its policy of quantitative easing. While this may have reduced the scale of the monetary tailwind, the level of inflation-adjusted interest rates is still barely in positive territory in the US and remains deeply negative in Europe. It is hard to argue people are suddenly being tempted to save rather than spend. 

The responsibility for the downturn in global corporate sentiment and stock markets lies at the doors of the White House. A 10 per cent tariff is now being applied to $250bn of US imports from China, with the risk that this rises to 25 per cent in March if Beijing and Washington cannot turn their temporary trade truce into something permanent. Chinese new export orders are tumbling. The business surveys in Europe are just as bad. It is no wonder that companies, gripped by uncertainty, are once again deferring investment.

So far the US economy has not been affected. The US Tax and Jobs Act was enough to distract US companies from what was going on elsewhere in the world. But this fiscal sugar rush is set to fade through 2019, from adding roughly 1 percentage point to quarterly annualised growth in the fourth quarter of 2018 to zero by the end of the year.

The drag of slowing global demand will start to bite for corporate America, at the same time as uncertainty weighs on intentions for capital expenditure and weaker stock markets dent consumer sentiment. Activity in the US energy sector will slow given the sharp fall in global oil prices in recent weeks, which is partly due to falling expectations of global demand. When oil prices fell in 2015 investment in the energy sector halved. This contributed to weakness in overall US gross domestic product. 

Is all this enough to prompt an outright recession and a more meaningful bear market? It is possible that a vicious cycle takes hold whereby companies cut back not only on capex but on hiring. A softening labour market could then slow consumer spending, the bedrock of the US economy.

This is clearly not the outcome the US administration is hoping for, particularly given the proximity of the next presidential elections. So will we see a more amicable approach to trade in 2019? Possibly. But we cannot be sure. There remains a lot of support in the US for a tougher approach to China.

Such binary geopolitical risk creates a conundrum for asset allocators. Aggressively removing riskier bets from portfolios will prove prescient if the vicious cycle takes hold. In such a scenario, longer-dated US government bonds may offer considerable upside given that the Fed’s rate rising cycle will end and focus will turn to rate cuts.

However, should the US and China reach an agreement, the chance of a significant snap back in risk appetite is high. Markets could quickly warm to equities given that the recent sell-off has cut valuations. In such a scenario, the market narrative could swiftly return to concerns about the strength of the US economy and the threat of inflationary pressure. All of which would hurt bonds.

So how to deal with this two-way risk? A gradual rather than dramatic shift in allocation seems most appropriate. For example, investors may wish to up their allocation towards fixed income, although a global reach is imperative given the slim pickings offered by European bonds. The Bank of England has made little progress in normalising rates given Brexit paralysis and the ECB has not even started raising rates. This prevents European cash or longer-term bonds providing scope for meaningful appreciation if times do get tough.

Investors seeking shelter in corporate bonds over equities should also be mindful of the rise in corporate leverage that has accumulated over the past decade. Indeed, this is the clear area of excess that has built in this expansion and may well be near the epicentre of concerns in the next recession.

Investors would be better off sticking with equities but seek more defensive positions. Consumer staples, telecoms, utilities and healthcare sectors tend to perform better in a downturn, but, in addition, investors can move to more defensive styles such as value and quality stocks, or those that stand out because of the quality of earnings, profitability and financial risk.

In the average of the past three US bear markets, when the S&P 500 fell 40 per cent, value stocks dropped 34 per cent and quality by 29 per cent, according to JPMorgan Asset Management’s quality index and calculations based on the S&P 500 and the Russell 1000 Value index.

Portfolios can be tweaked to improve resilience but there is no single strategy that can cope with such binary geopolitical risk. Investors will need to be fully alert and nimble in 2019 to react to the trade strategy the US administration decides to pursue.

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