Q: What is the next phase of U.S.-China trade tension?

Trade talks between the U.S. and China have deteriorated further, with the U.S. raising tariffs on USD 200billion worth Chinese exports from 10% to 25% last week. In retaliation, China announced on Monday that it would impose tariffs on USD 60billion worth of U.S. goods from June 1st, but both sides are still in negotiation. Washington reportedly continues to apply pressure on Beijing by threatening to impose tariffs on the rest of Chinese exports to the U.S., if an agreement is not reached within one month. Last week’s episode reminds us of two issues. First, an agreement is still the more likely outcome, even though the future path is likely to be bumpy. Moreover, the competition in technology and economic dominance, and geopolitical rivalry will continue in the years to come. Second, the new round of tariff increases has revived an uncertain corporate outlook. The recovery in sentiment in 1Q 2019 could take time to recover again, even if an agreement can be reached in the near term. This could delay the recovery in the global trade cycle and growth momentum. This second factor could influence market sentiment in the near term and exacerbate market volatility.

Looking back to the height of trade tension in April to November 2018, different asset classes behaved in different ways (refer to Exhibit 1 on the next page). Not surprisingly, downbeat sentiment hurt northeast Asia the most, including China, Taiwan and South Korea. These economies are highly connected through the manufacturing supply chain. Southeast Asia and India were relatively less affected, being further from the epicenter of the trade war and potential beneficiaries of diversification in Asian supply chain away from China. Meanwhile, in fixed income, emerging debt had a tough time. We believe this is more to do with the U.S. Federal Reserve (Fed) engaging in policy normalization, and the U.S. dollar strengthening. In fact, Asian fixed income was relatively resilient, only weighed down by the rising risk-free rates at the time.

Even though the trade tension backdrop seems to be reverting back to 2018, several differences now imply asset return outcome could also be different. As mentioned earlier, the Fed is now content with the current level of interest rates. In the event of the trade war escalating further and threatens U.S. economy growth, it has the option to ease monetary policy further. A more patient Fed also allows developed market and Asian central banks to opt for rate cuts, such as India in April, and New Zealand, Malaysia and the Philippines in recent weeks. China’s policy stance has also u-turned compared to a year ago, shifting away from corporate de-leveraging to supporting growth. More tariffs could mean more fiscal and monetary stimulus to protect domestic demand. 

EXHIBIT 1: Asset class returns over last year’s period of trade turmoil
Returns over 31/3/2018 – 30/11/2018

Source: Bloomberg Finance L.P., FactSet, MSCI, Standard & Poor’s, J.P. Morgan Asset Management.
Equity returns are total returns based on MSCI indices, except the U.S., which is the S&P 500 and China A, which are based on the CSI 300 index in U.S. dollar terms. Based on Bloomberg Barclays U.S. Aggregate Credit – Corporate High Yield Index (U.S. HY), Bloomberg Barclays U.S. Aggregate Credit – Corporate Investment Grade Index (U.S. IG), J.P. Morgan Government Bond Index – EM Global (GBI-EM) (Local EMD), J.P. Morgan Emerging Market Bond Index Global (EMBIG) (EMD), J.P. Morgan Government Bond Index – Global Traded (DM Government Bond), Bloomberg Barclays Aggregate (Global Bonds), J.P. Morgan Asia Credit Non-investment Grade Corporate Index (Asia Corporate HY), Bloomberg Barclays Global U.S. Treasury – Bills (3-5 years) (U.S. Treasury) and Bloomberg Barclays U.S. Treasury – Bills (1-3 months) (Cash). Past performance is not a reliable indicator of current and future results. Data as of 10 May 2019.

Investment implications

U.S. China trade tension is likely to remain a source of market volatility in months ahead, with investors reversing some of the valuation re-rating that took place earlier in the year. This would call for a more diversified approach in asset allocation between equities and fixed income and focus more on volatility management. In equities, cautious sentiment is likely to dominate in the near term over worries on earnings, with valuations taking the heat.

Nonetheless, the structural growth story for many Asian economies remains intact, and this requires investors to take a more active approach in sector and company selection. ASEAN and India should show greater resilience and even Chinese consumer demand should be supported by economic stimulus. High dividend stocks also provide some buffer against market volatility and more consistent cash flow contributing to return. Prospects for more stimulus from Beijing could also help to cushion investor sentiment.

In fixed income, despite more uncertainties facing the economy, willingness by global central banks to keep monetary policy loose should prompt investors to continue to look for yields. This would point towards global high yield corporate debt, which continues to enjoy low default rate. Asian fixed income’s direct exposure to trade is modest. Risk aversion could prompt temporary strength in the U.S. dollar but we believe Asian economic fundamentals are sufficiently strong to weather such negative factors.