U.S.-China trade tensions have escalated, echoing our midyear outlook protectionist push theme, and bond yields have fallen to new lows. We do not see a near-term recession, with no clear signs of financial vulnerabilities and central banks helping extend the cycle. Yet the protectionist push has been stronger than we expected, raising the risk of accidents. This has potential to challenge our modestly pro-risk stance.
The U.S.-China trade standoff has materially escalated amid tit-for-tat actions, just as summer ends in many parts of the globe and back-to-school season begins. The latest twists and turns include newly announced U.S. and Chinese tariffs, and increasingly unpredictable U.S. policy actions, particularly around trade, that threaten the longstanding institutional underpinnings of the global economy. Our indicator of market attention to the geopolitical risk of worsening global trade tensions has risen in response, though is still short of record highs struck in the summer of 2018. See the uptick in the far right of the chart above.
Intensifying protectionist push
We identified the protectionism push in our midyear investment outlook as the most important market driver – and this risk has only intensified since. The recent escalation in the U.S.-China conflict has injected more uncertainty into business planning, weakening economic activity. Our macro indicators point to a decelerating global expansion. And we view a comprehensive U.S.-China deal as unlikely in the near term, with the best outcome now a trade truce until November 2020. We now expect some level of tariffs on most of U.S.-China trade for an extended period of time. Trade spats have also continued to broaden beyond the U.S. and its allies, and other geopolitical risks abound, including the near-term prospect of a “hard Brexit.”
The protectionist push has so far outweighed the market impact of the central bank dovish pivot that underpins another of our key outlook themes: Stretching the cycle. Additional central bank stimulus, actual and expected, should help stretch the cycle. After the Federal Reserve disappointed markets in July, we see the European Central Bank likely announcing a stimulus package and the Fed cutting rates again this month. The Fed may cut by more than we initially expected, but we still view the one percentage point of additional easing that markets are pricing in by end-2020 as excessive. However, risks abound. Monetary policy is no cure for a full-blown trade war. There is limited policy space to deal with a future downturn. And while the trade war is unambiguously bad for growth, we still see potential for U.S. inflation to rise in the near term due to the direct one-off impact of tariffs, and in the longer term, due to trade tensions’ adverse impact on production capacities. As for growth signposts, we are closely watching U.S. labor market and consumer data for signs of spillovers from a manufacturing slump.
Our key investment themes and views remain unchanged, but we are cautiously watching fundamentals and price action due to the intensifying protectionist push and resulting plunge in yields. A worsening of this backdrop would challenge our broad preference for equities over bonds. Government bonds displayed their ability to provide portfolio ballast this summer, but some may be nearing their effective lower bound in yields. Within equities we still like U.S. stocks for their reasonable valuations and quality bias. Read more market insights in our Weekly commentary.