This blog post originally ran as an Institute Alert commentary by Darrell Cronk, CFA, President, Wells Fargo Investment Institute and Chief Investment Officer, Wealth and Investment Management.
- 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 equites 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.
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.
Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Small- and mid-cap stocks are generally more volatile, subject to greater risks and are less liquid than large company stocks. Bonds are subject to market, interest rate, price, credit/default, liquidity, inflation and other risks. Prices tend to be inversely affected by changes in interest rates. High yield (junk) bonds have lower credit ratings and are subject to greater risk of default and greater principal risk. Real estate has special risks including the possible illiquidity of underlying properties, credit risk, interest rate fluctuations and the impact of varied economic conditions.
Sector investing can be more volatile than investments that are broadly diversified over numerous sectors of the economy and will increase a portfolio’s vulnerability to any single economic, political, or regulatory development affecting the sector. This can result in greater price volatility. Risks associated with the Consumer Discretionary sector include, among others, apparel price deflation due to low-cost entries, high inventory levels and pressure from e-commerce players; reduction in traditional advertising dollars, increasing household debt levels that could limit consumer appetite for discretionary purchases, declining consumer acceptance of new product introductions, and geopolitical uncertainty that could affect consumer sentiment. Real estate investments have special risks, including possible illiquidity of the underlying properties, credit risk, interest rate fluctuations, and the impact of varied economic conditions. Risks associated with the Technology sector include increased competition from domestic and international companies, unexpected changes in demand, regulatory actions, technical problems with key products, and the departure of key members of management. Technology and Internet-related stocks smaller, less-seasoned companies, tend to be more volatile than the overall market. Utilities are sensitive to changes in interest rates, and the securities within the sector can be volatile and may underperform in a slow economy.
The FTSE 100 Index is a capitalization-weighted index of the 100 most highly capitalized companies traded on the London Stock Exchange.
Hong Kong Hang Seng Index is a market capitalization-weighted index of 40 of the largest companies that trade on the Hong Kong Exchange. The Hang Seng Index is maintained by a subsidiary of Hang Seng Bank, and has been published since 1969. The index aims to capture the leadership of the Hong Kong exchange, and covers approximately 65% of its total market capitalization. The Hang Seng members are also classified into one of four sub-indexes based on the main lines of business including commerce and industry, finance, utilities and properties.
NASDAQ Composite Index measures the market value of all domestic and foreign common stocks, representing a wide array of more than 5,000 companies, listed on the NASDAQ Stock Market.
S&P 500 Index is a market capitalization-weighted index composed of 500 widely held common stocks that is generally considered representative of the U.S. stock market.
An index is unmanaged and not available for direct investment.
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