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How we’re positioning portfolios amid global trade war fears

Steven Wieting

By Steven Wieting

Chief Investment Strategist

July 23, 2018Posted InInvestments and Investment Strategy

The Citi Private Bank Global Investment Committee (GIC) cut its Global Equity allocation by 2.5 percentage points and raised its Fixed Income allocation by an equal 2.5 percentage points.

This leaves us 1.5% overweight in equities, 1.5% underweight in fixed income, with a neutral cash allocation. Within Fixed Income, shorter-term high quality US debt and inflation-linked debt was raised to augment cash returns.

Our allocation shift is driven by US trade policy, which now appears less predictable. US tariffs and retaliatory measures have left world financial markets highly reactive. The risk/reward balance thus appears somewhat less attractive, even if trade issues get favorably resolved.

The outcomes of political negotiations are increasingly material to the economic outlook and have become a more influential driver of returns. To be clear, new trade agreements that lower or preserve current tariffs could still result in a significant relief rally for many beaten down equity market segments across the world.

Present US economic growth is strong and EPS gains will very likely exceed 20% for a second straight quarter, and possibly for the full year. We believe the global expansion remains intact, and growth outside the US is underappreciated by investors.

However, an escalating trade war would weigh more heavily on the world growth outlook, including that of the US. The impact on profit margins can potentially be many times that of the impact on measured GDP growth. Amid currently reduced policy visibility, we see our reallocation today as a transitional step.

We may raise or lower risk allocations based on pending trade and other policy developments. A highly diversified multi-asset class portfolio approach remains a potent risk management tool in today’s environment. Derivative hedges and structures may also be useful for appropriate clients.

In Global Equities, we reduced allocations to both Developed and Emerging Equities based on two criteria: 1) Markets where there has been relatively little valuation impact from trade fears, but where the economic impact of a trade war could be substantially greater. This led us to reduce allocations to Canadian and Mexican equities. 2) Markets where we have low or reduced conviction in fundamentals.

This led us to reduce allocations to emerging markets in Europe, the Middle East, and Africa as well as moderately paring back overweight positions in Developed Europe. Given very significant negative reactions and low valuations in in German, Chinese and Brazilian equities for a variety of trade and non-trade reasons, we’ve maintained overweights in these markets, albeit reduced overweights in Germany, Hong Kong and other trade-dependent Asian and European markets.

In Global Fixed Income, we added to overweight positions in short-term US Treasuries, short-term US corporate debt and municipal bonds for US tax-payers. We added a new overweight position in US Treasury inflation-linked debt.

The position helps add an asset that is negatively correlated to risk assets while also earning a return above the US inflation rate. (US Inflation may be somewhat augmented by tariffs or trade disruptions.) As discussed below, the US administration reportedly turned down initial trade offers from China, Canada and Mexico, while expanding steel and aluminum tariffs to nearly all global suppliers. Foreign governments have retaliated in kind. President Trump subsequently threatened tariffs on much higher valued autos trade and sharply raised proposed tariffs on China.

We would view an imposition of autos tariffs as a major escalation that will lead to wider retaliation. We do not believe a sharp further acceleration of trade actions is discounted by global markets. Meanwhile, a quick resolution of trade disputes would generate a sharp rebound in trade-sensitive equities, and likely in US long-term interest rates.

This keeps us from overweighting long duration bonds tactically, even though they remain a valuable portfolio component with a full, strategic weight. On a net basis, financial markets efficiently “straddle’ the two scenarios for the trade dispute (“quick deals” vs “just the beginning”). With some “defensive” equities rising, on a net basis, Global Equities are likely about 5% lower as result of the trade dispute.

If there were no lasting damage to economic activity, a good portion of this could add to future returns. At the same time, the nine-year old US economic expansion faces the increased hurdle of rising short-term US interest rates and tightening labor markets.

This has raised US cash yields already 150 basis points above 10-year government bond yields in other developed markets. Over time, we would expect to increasingly add to US short-term fixed income as the Fed tightens, and would consider overweighting US long-term bonds when the US economic expansion appears at significant risk of peaking.

Importantly, we see Emerging Markets (EM) and Emerging Asian equities in particular as the strongest return public investment over the coming decade. While we may make shorter-term tactical allocation shifts in the asset class as a result of US trade and monetary policy developments, any such changes would be very unlikely to change our longer-term strategic views.