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Increasing portfolio quality amid trade war risks

Steven Wieting

By Steven Wieting

Chief Investment Strategist and Chief Economist

June 3, 2019Posted InInvestments and Investment Strategy

The Citi Private Bank Global Investment Committee held a meeting on 3 June and further reduced our risk allocations, adding to downward adjustments made in mid-May. Since our last meeting, trade policy concerns have broadened with seemingly less predictable outcomes. While asset allocation across fixed income and equities is performing well as a mitigator of risk and we advise maintaining broad investment exposures, we are tactically reducing equities across world markets by a further 3 percentage points, adding to high quality US fixed income and cash in equal amounts to reflect changing risks.

We don’t believe a severe escalation of US tariffs and retaliation measures are embedded in current corporate earnings estimates. While risks are rising, we also don’t believe a US recession shortly ahead is inevitable. If we see excessive fear priced into markets or favorable resolutions of trade disputes, we may reverse these steps. After today’s changes, the global equity allocation is underweight by 2 percentage points, fixed income overweight by 1.5 percentage points and cash overweight by 0.5 percentage point. 

Financial markets weakened over the course of May as investors came to see a lower probability of a quick resolution of trade disputes, and yet global equity total returns year-to-date are nearly 10%. Current indications suggest the US and China are too far apart on many issues to come to a quick trade agreement without first further escalating tariffs and retaliation. News that the US would apply escalating tariffs to Mexico, a free-trade zone member, over non-trade-related issues suggests that the Trump administration sees tariffs as a sustainable substitute to cooperation on a wide range of matters. A tariff of 25% on all Chinese and Mexican imports – while merely possible at the moment – would be equal to 17% of large capitalization US corporate profits. This excludes retaliation, any increase in non-tariff barriers, or business disruptions which would seem likely in an escalation. Such tariffs on the US side (paid by US importers) would exceed 80% of the size of total corporate and individual income tax cuts put in place in 2018. This also excludes potential action on autos trade.

In our view, the speed of the market’s negative reaction to the trade conflict, and changes in market prices to date make adding risk hedges the relatively better strategy than changes in cash portfolio allocations (please see May 21, 2019 Global Strategy Bulletin). This recognizes the potential for markets to rebound swiftly to unpredictable news developments. In addition, poor equity market sentiment readings, cautious investor positioning, and merely modest valuation concerns suggests the chance of a sharp rebound. As we discuss (see May 31, 2019 Global Strategy Bulletin) history suggests wholesale portfolio timing can lead to deep underperformance. Nonetheless, the inverted US yield curve and vulnerable business sentiment readings suggest a broader change in risks and opportunities that we choose to reflect in standard portfolio allocations. A timely resolution of the growing list of trade disputes could change our assessment and potentially lead us to reverse our latest moves. In the interim, it seems likely that negative business and financial market impact will be a source of pressure on policymakers to come to agreements, which is unfavorable for portfolio risk.

US fixed income markets now price in two 25 basis point easing steps by the Federal Reserve this year and further cuts in 2020. We also see action by the Fed dependent on trade developments. If the current weakening in financial conditions and negative trade impact spreads to overall domestic economic weakness, the Fed would likely follow financial markets with cuts, thus avoiding a “tightening” that would come by shifting up market interest rates. However, the Fed is likely to be reactive to trade news rather than leading in our view. Importantly, current trade risks are quite different from the events of 4Q 2018 when US monetary policy itself caused economic risks. The Fed was then able to independently correct its misalignment. The Fed cannot stem trade policy risks or offset negative economic consequences in real time.

With US inflation low, the Federal Reserve will likely see any jump in consumer prices on tariff impact as a supply shock, quite different from lasting inflation. We would thus not expect lasting concerns from the Fed’s part that would cause them to hold US monetary policy unnecessarily tight. While market interest rates could jump sharply if trade risks were settled swiftly, we again believe the broadening out of US demands means various trade risks have become harder to resolve swiftly.

Non-US equity markets are valued about 12.5X current year EPS estimates, which are under risk of downward revision. This is an attractive long-term entry point, but we have cut both US and non-US developed and emerging market equity positions across the board in today’s tactical move. We see income-generating, less cyclical equities as relatively appealing. Our overall portfolio recommendation has the potential to generate an increasingly attractive 2.7% yield with continued growth prospects beyond the current period of heightened trade risk.