The U.S.-China trade war—what could drive further market volatility

The latest escalation in the U.S.-China trade war has put investors on edge, creating a choppy market environment.

To recap: U.S. negotiators accused China of backtracking on earlier commitments, and on May 10, the United States increased tariffs on $200 billion of Chinese imports, from 10% to 25%. China responded on May 13 with a pledge to place tariffs on $60 billion of U.S. imports beginning June 1.¹ The direction the talks take from here is likely to have a broad impact across asset classes and the global economy, in our view. We’ll review what we believe are the most important elements to watch and discuss considerations for portfolio positioning in what could be a stretch of elevated market volatility, absent some sort of resolution in the U.S.-China trade war.  

Monthly business surveys from the Institute for Supply Management (ISM) on sentiment among manufacturing and services companies provide timely indicators on the corporate outlook and the broader economy. A reading above 50 generally means that businesses are in an expansionary environment, and below 50 would suggest contraction. Recently, we’ve seen a downward shift in sentiment; the manufacturing survey and the services survey both climbed to around 60 in August and September of 2018, but the most recent readings from April saw them drop to 52.8 for manufacturing and 55.5 for services.²

CEOs, CFOs, and COOs are in a tough position because higher tariffs can disrupt their global supply chains, as they may need to reach supply agreements with new trading partners and cancel old agreements to keep costs in line. Without new agreements, U.S. companies wishing to maintain their profit margins may find they need to pass on the costs of higher tariffs by raising prices on consumer goods—an outcome that would show how tariffs are really a tax on the U.S. consumer. Uncertainty over the scope and duration of the tariffs could also weigh on companies’ expansion plans, capital spending, or hiring. 

We believe the tariffs, taken together, may have a larger impact on business sentiment than GDP estimates would suggest, and the negative impact from tariffs could cause the recent slowdown in earnings growth to become more pronounced. In coming months, business surveys could provide a strong indication of any further downturn in sentiment. Business leaders were already on edge before the new tariffs were introduced, and any survey readings below 50 would suggest earnings estimates will likely need to come down further. 

To offset the effect of the latest U.S. tariff increase, Chinese policymakers could choose to weaken the yuan relative to the U.S. dollar, helping to keep China’s exports as competitive in a global market as they were prior to the tariff increase.

However, such a move wouldn’t be without risks, as any excessive weakening of the yuan could trigger an exodus of capital from Chinese markets and reduce liquidity. China’s currency has traded in a range of 6.20 to 6.98 yuan per dollar over the last five years,³ and we believe any further weakening above 7.00 could be a negative sign for risk assets broadly. There’s some recent historical precedent here, as the yuan weakened meaningfully in the risk-off global equity market environment of 2015/2016; it did so again prior to the sell-off in late 2018.³ Amid the recent escalation in the U.S.-China trade war, the exchange rate has climbed toward 7.00, and it could be a key indicator to watch in coming months. 

While the escalation in the U.S.-China trade war has recently weighed heavily on emerging-market equities, volatility across other asset classes has been relatively muted, particularly for developed-market equities and U.S. high-yield bonds.³ However, as frictions resulting from the U.S.-China trade war continue to weigh on markets, risk assets could experience further volatility on the downside, in our view.

We believe investors and their advisors should use this time wisely to ensure that portfolios’ risk levels are aligned with investment objectives; portfolio reviews performed after volatility has already hit are usually too late. Positioning themes that are highlighted in our latest Market Intelligence, our asset management network’s view of the investment landscape, remain focused on increasing exposure to quality characteristics in equities and bonds alike.

On the equity side, we continue to favor a barbell approach, with balanced exposure to certain sectors for offense (information technology and healthcare) and others for defense (consumer staples and utilities). As for fixed income, we would increase duration to just shy of six years—similar to the average duration of the Bloomberg Barclays U.S. Aggregate Bond Index—while moving up in quality to emphasize investment-grade corporate bonds and mortgage-backed securities (increasing allocations to core/core plus strategies).

Overall, such positioning is designed to create a balanced portfolio with potential volatility just below that of the broader market, enabling investors to participate in the market’s potential upside while providing a measure of downside protection for what could be choppier markets ahead.

1 China announces tariff hikes on $60 billion in US goods in retaliation for Trump penalties, The Associated Press, 5/13/19. 2 ISM Manufacturing Report on Business, ISM Non-Manufacturing Report on Business, April 2019. 3 FactSet, as of 5/20/19.