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Institute Alert: Summer Flip Flops—Stumbling Deeper Into a Trade War

Wells Fargo Investment Institute - August 26, 2019

by Darrell Cronk, CFA, President, Wells Fargo Investment Institute, Chief Investment Officer, Wealth and Investment Management and Paul Christopher, CFA, Head of Global Market Strategy  

Key takeaways

  • Global equity markets have stumbled in August, even as fixed-income markets continue to attract inflows and mark higher prices and lower yields.
  • A U.S. economic recession does not appear imminent, but we view the increasing unpredictability of the U.S.-China trade dispute as a clear risk to the economic expansion.

What it may mean for investors

  • After global financial markets returned strong gains through July, we favor positioning conservatively, in order to accommodate more challenging times ahead.

August has not been kind to Wall Street or to global equity markets. Nearly all the major global equities indices had dropped by more than 4.5% this month (through August 23), with even larger declines in the NASDAQ (-5.2%), Hong Kong’s Hang Seng (-5.8%) and U.K.’s FTSE 100 Index (-6.5%). Meanwhile, U.S. Treasury yields have declined to their lowest levels since 2016, while U.S. and U.K. long-term sovereign bond yields remain below those of shorter maturities, a potential danger signal for the economic expansion.

No recession—yet—but the trade dispute raises the risk

A U.S. recession does not seem imminent, but U.S.-China trade war escalation poses a growing risk to curtail the economic expansion. Both sides raised tariffs only modestly on August 23, but raised the rhetoric substantially. Worse, there is no obvious way in sight for both sides to back down and still save face. We have written since the onset that the trade war will have to escalate in order to deescalate. The two sides are still escalating the conflict, and the next scheduled meeting between President Trump and President Xi is not until November 16 and 17 in Santiago, Chile. 

Last week, President Trump stated that, “the U.S. doesn’t need China or would be better off without them.” We disagree with this view—as we see the two economic cycles as inextricably linked. Many U.S. and Chinese companies have absorbed the cost of the past year’s tariffs, but as some of these tariffs are scheduled to reach 30%, we expect a stronger negative impact on corporate earnings. There are global implications, too.  Trade is needed for global manufacturing; manufacturing is needed to generate company earnings; earnings are needed to drive hiring and capital spending; and hiring is needed for consumer spending and confidence. So goes the global economic cycle, and the negative effects are mounting. Since tariff escalation began, 12-month U.S. import growth from China has declined from the 12% level to -36%. 

What may come next

Currency policy could remain a tool for pressure. The fear lingers across global financial markets that both countries may devalue their currencies in a competition. There have been suggestions from the Trump administration that the U.S. dollar is too strong. For its part, Beijing has been allowing its currency, the yuan, to depreciate periodically. We believe that China will continue to weaken its currency slowly and methodically, and in line with the depreciation in other Asian currencies. Until the intentions of policy makers become clear, even a little currency depreciation could add to equity market volatility.

Policy supports are coming. Will they help? The global nature of the recent economic slowdown calls for a broad policy response. Emerging market countries have thus far led the charge with 18 central-bank rate cuts in the past three weeks alone. U.S., European, and Japanese central bankers also are likely to ease policy. It’s unclear whether lower borrowing rates will appeal to borrowers. In the U.S., for example, commercial loan demand growth among large companies is slowing, and it is already contracting among smaller companies. More generally, lower interest rates may not generate much positive effect anywhere in the world, if the trade dispute continues to aggravate the slowing global economy. Additional fiscal policy stimulus discussions have entered the narrative lately. While it is possible, sizable late-cycle U.S. fiscal stimulus would be somewhat unprecedented, difficult to fund, and politically challenging to pass heading into an election year. 

The U.S. and China seem set on unpredictably creative new ways to escalate their dispute. While tariffs are the tip of the spear, there also are other tools. China has not provided specific details about which U.S. goods it will hit with tariffs. From the U.S. side, President Trump twice this month has reached for punitive measures that are unconventional and not previously used in this trade dispute. He abruptly declared China a currency manipulator on August 5, after his administration had rejected that designation as recently as May 28. His August 23 declaration that U.S. companies should leave China may seem to overreach, but it underscores that the U.S. may stretch for unconventional measures. 1 If this dispute should get worse before it gets better, investors may see more penalties chosen to be unpredictable and unexpected.

Perspective on the negotiations is important. Beijing has called on China for the same patience and endurance shown during the Korean War and the Long March (a reference to a 6,000-mile march by Communist forces in 1934-1935, during their fight with Chinese nationalist forces). President Trump, on the other hand, talks of trade wars being easy to win, tariffs being paid by China, and China needing a deal soon. These two narratives remain far apart, even though both leaders need a trade deal to promote economic health and maintain their domestic political support.

What we believe investors should be doing

Challenging times likely lie ahead. We believe that investors should position their portfolios more conservatively, especially after strong year-to-date gains. Practically speaking, this means keeping capital available to put to work opportunistically, as the coming 12 months unfold. More specifically:

Stay up in quality across equities. Quality has a number of interpretations, but as we get closer to the end of the cycle, strong company cash positions relative to debt should become a key quality measure. We still favor the U.S. Information Technology and Consumer Discretionary sectors for this reason. Investors needing income, but who find bond yields too low, can focus on stable growth and defensive yield—along with defensive quality in equities. Information Technology again, we believe, fits this need, and we recently upgraded Utilities and the Real Estate sector (including real estate investment trusts, or REITs) to neutral, indicating that we favor taking exposures in these sectors back to long-term target allocations.

Reduce exposure to higher-risk asset classes for which fundamentals are deteriorating. We have favored reduced exposures to small-cap equities and high-yield debt since the beginning of the year. We recently resumed a neutral view of emerging market equities (positive long-term earnings trajectory, but near-term downside could increase if the trade dispute escalates further). We still find high-grade corporate bonds attractive. 

Be patient putting new cash to work. The S&P 500 Index could vary between 3000 and 2700 (or lower) in the coming months. Many investors dislike taking profits on successful positions, but this pruning may be the best way to generate returns—as long as investors are not in too much of a hurry to put that cash back to work. 

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1 President Trump’s order claims authority under the International Emergency Economic Powers Act of 1977 (IEEPA). The IEEPA allows the president to utilize sanctions, investigations, or confiscation of property—but first requires “a national emergency” that can only be exercised when an “unusual and extraordinary threat exists”. The IEEPA does not allow for the president to order the repatriation of private assets held overseas. Moreover, Congress can override a presidential order with a two-thirds majority, although this is admittedly a high bar with a divided Congress and heading into an election year.