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May Investment Strategy: Dealing with the governments we deserve

Key points

  • US-China tensions are back with a new round of tariff increases and threats of further escalation
  • First quarter GDP data surprised on the upside in the US (significantly), in China and in Europe
  • The demand breakdown as well as latest Chinese activity data and global business surveys confirm the fragility of the ongoing recovery to adverse shocks
  • The European elections do not represent a risk as such but have interesting domestic and regional implications
  • We have lowered our risk appetite by a notch through an underweight in equities while overweight in fixed income spread products (US high yield and Emerging Markets high yield).

The Tariff Man is back…

The risks of a US-China trade war have increased markedly since our previous Monthly Investment Strategy. Following a briefing from his US Trade Representative Robert Lighthizer, President Donald Trump announced an increase in tariffs from 10% to 25% on $200bn of US imports from China and threatened a further 25% on the remaining $300bn. The former effectively represents the postponed enactment of the US tariff increase (initially scheduled on 1 March) which we had included in our 2019 Outlook baseline scenario.

After months of relatively positive US-China “negotiations progressing well” headlines, this latest step-up in US protectionism comes as a bad surprise for financial markets – which went into risk-off mode – and most observers. Why this setback? First, we recognise that US policymakers and White House trade policy has swung sharply in recent months. Second, the US-China confrontation goes much deeper than trade and, while we still expect a trade deal to be reached over the summer in our baseline scenario, we characterise this as an extended truce rather than permanent peace. Third, and most importantly for financial markets, President Trump may be counting on a US Federal Reserve (Fed) bail-out; a sort of “Too Crazy to Fail” policy. Since its December communication mistake (not a policy one in our view), the Fed has been shifting tone and forward guidance (the ‘dots’), clearly reducing its previous hawkishness. This policy stance shift to date is an adequate reaction to the tightening of financial conditions, but it also affects President Trump’s best alternative to a negotiated agreement, offering the White House room for a more hawkish trade policy.

Don’t go breaking my recovery

This new round of tariffs comes at a time when our hopes of a swift cyclical recovery were beginning to be confirmed. US GDP accelerated to 3.2% (annualised) in the first quarter (Q1), surprising on the upside. And even if erratic, short-term factors boosted the start of the year, we still see Q2 growth holding up at 2.0%, above trend, while the US unemployment rate is already at a 50-year low. In the eurozone as well, Q1 GDP growth was higher than expected across almost all major countries, at 1.6% (qoq annualised) after a worrying 0.9% in Q4 2018. This upside surprise may, however, be short-lived seeing manufacturing business surveys: German orders for example recorded their worst performance in a decade. Hence our careful upgrade of our eurozone growth forecast for 2019, up 0.1 percentage point to 1.1% with risks, in our view, skewed to the downside.

Looking east, the latest batch of monthly data has been mixed: China’s activity data were soft across metrics in April. We had anticipated a seasonal correction after the strong March rebound but the scale of pullback was sobering, if not worrying. Purchasing Managers’ Index (PMI) data also softened slightly in April in various emerging markets, erasing only part of the improvement witnessed over the past couple of months. That said, a number of East Asian economies had released data which suggest that export and industrial growth was bottoming out. Altogether, we maintain our outlook of a sequential economic improvement sustained by China and a dovish Fed but we cannot stress enough how vulnerable the momentum is to adverse shocks.

Why so serious? More populism on the way

Unfortunately, post-global financial crisis politics have regularly dismissed mutually advantageous, reasonable solutions. So it seems in the UK, where the seven-month Brexit extension agreed at the March European Union Summit delivered no progress in cross-party talks. A “Meaningful Vote 4” is scheduled for the week of 3 June (with a surprise outcome still possible), likely followed by Prime Minister Theresa May’s resignation, a Tory leadership contest, and a growing probability of snap general elections. While a Halloween “no deal Brexit” remains a credible risk, our baseline sees a further extension in Article 50.

Politics is worth following in Europe too. This is not because of the expected strong rise of populists at the 23-26 May European Parliament elections. Indeed, despite Italy’s Deputy Prime Minister Matteo Salvini’s best efforts, the alliance of Eurosceptic parties is fraught with divergences and is set to fall short of a majority. Rather, an upside surprise is not likely, with increased political fragmentation a near certainty. Instead, as outlined in our Theme of the Month, these elections look important for domestic political implications. These could include the stability of the government coalition in Italy, German Chancellor Angela Merkel’s succession and a test for French President Emmanuel Macron after six months of “yellow vests”. We will also wait for the subsequent round of top appointments, especially at the European Central Bank with President Mario Draghi and Executive Board member Benoît Coeuré leaving by year end.

Asset Allocation: risk appetite modest but on the rise as spread product carry attractive

The strength of the rally in risky assets in Q1 – record breaking for some markets – was bound to raise investor unease as to what came next. With the ‘sell in May’ adage foremost in minds and markets looking for an excuse to correct, President Trump’s tweets duly obliged – rekindling the US-China trade war. The market correction that ensued has been anything but dramatic. The S&P500 is less than 3% below its recent peak and was less than 5% down at its worst. The 10-year US Treasury yield is back below 2.40%, its low over the past two years. This should not surprise given the prevailing market perception that downside scenarios would prompt central banks to respond fittingly – and ease policy – with the Federal Reserve leading the pack.

The correction notwithstanding, cross-asset returns still exhibit a bull-market pattern year-to-date (YTD), with equities leading high-yield (HY) credit, which in turn is performing better than investment-grade (IG) credit, which itself is outperforming government bonds. Cross-asset correlations too have remained stable and close to historical norms. This macro backdrop leaves us with a modest risk appetite that we express through our credit spread product, namely a modest overweight in US dollar and emerging market high yield. While a major market correction like that in Q4 2018 is unlikely, further bouts of market volatility are more likely than not. ‘Keeping powder dry’ in anticipation of better entry levels appears a prudent strategy at this juncture.

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