Multi-Asset

Tariffs remain a key unknown

With the only certainty being uncertainty, markets have maintained their composure through the escalation of US trade developments with China.

10/08/2018

Simon Doyle

Simon Doyle

Head of Fixed Income & Multi-Asset

Generally speaking, risk assets performed well in July with most global equity markets posting solid gains. Significantly, “value”, as a style factor, performed well compared to “growth”, which benefitted our core global equity holding (Schroder QEP Blend Strategy) which has an inherent value bias and which has been hurt for some time by the persistent outperformance of “growth” and “momentum” over “value”. Credit spreads retraced some of their losses with global high yield having a decent month despite relatively narrow spreads and evidence of broader fundamental and technical deterioration. While bond yields moved higher in July, our very modest duration positioning of 0.7 years helped protect the portfolio from this negative drag.

While measured market volatility may not have picked up much this year, uncertainty about the future path of economies and markets clearly has. While we can thank President Trump for some of this, I’m not sure that the path forward would have been any more certain without him. In fact, Trump has probably made uncertainty the one certainty (if that makes any sense!). Markets are currently unperturbed. Equity markets continue to grind higher. A 21% fall in the Facebook share price is seen as an idiosyncratic issue, causes no more than a minor palpitation, and then US market again edges higher, closing in on its January highs. Clearly happy days!

We can understand this bullish sentiment. Economies are growing, the latest US profit season was good, and while inflation pressure is building, there isn’t yet the smoking gun to declare inflation back and a problem for investors or policy makers. The real risk for investors is recession, and while our research suggests that the recession clock has started to tick, the timing is beyond the immediate consciousness of most investors. Let the good times roll.

Understanding where this bullish sentiment comes from is not the same as agreeing with its consequences. A more balanced take on the current state of play is that global growth momentum has peaked (particularly after allowing for the boost to US growth from tax cuts) and the negative impact of tariffs (directly) and business confidence (indirectly). Consistent with this we expect that US profit momentum has also peaked. A moderation in top line growth and a rise in costs should see margins moderate from here. The risk of a surprise to both investors and policy makers on the inflation side remains real. Significantly, this is occurring against a background of relatively full valuations for both equities (particularly US equities) and credit (particularly higher yielding/riskier credit). Our 3-year return forecasts for US equities have gone negative again. The last time they were negative was in January.

China can’t be forgotten either. Growth has slowed and the imbalances that have been well documented are having an impact. Policy has been eased, but the risks of a further moderation in Chinese activity can’t be dismissed.

From an Australian perspective, the outlook is benign but not without its risks. The RBA left rates unchanged at 1.5% and while doing nothing on rates for two years might seem somewhat boring, it is the right decision against an economy that is broadly growing at around trend. The unemployment rate has been relatively sticky above 5%, wage growth, inflation is barely within the RBA’s target range, and the housing sector (especially house prices) has already seen considerable tightening as lending standards rise and the availability of credit to the sector falls.

While most of this isn’t new news — the uncertainty over tariffs probably the exception — market prices have risen again and with the US equity market closing in on January highs, we have cut our equity exposure by a further 5% in recent weeks (mainly in Australian and US equities). This leaves us relatively defensively positioned in early August. We’ve also added some duration back into the portfolio. This should be viewed as a tactical position and seen against an overall position reflecting modest risk asset exposure. In broad terms though, we remain well positioned for an inevitable increase in volatility, a renewed bout of risk aversion, and rising inflation. Now is not the time to shoot for the stars — asset quality and liquidity are an important focus.

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