Over the last two weeks, investors have been on a disorientating roller coaster ride:
Through these twists and turns, our view is that the broad fundamentals of the market were mostly unchanged throughout.
1. Businesses need stability and predictability to make decisions, and this environment is anything but. If the ongoing decline in business confidence is severe enough, it would eventually spill over to the consumer side of the economy and labor markets. This drives up the risk of a recession.
2. The path to a Sino-US trade agreement remains tenuous, and we see at best 50-50 odds of a partial deal before the 2020 US presidential elections. Chinese policy makers are unwilling to concede on their redlines, such as industrial policy, market access and enforcement mechanisms, which form core US requirements. It also sees the removal of all trade war tariffs as a precondition for a deal. This is a high bar.
On the other hand, Trump cannot agree to a weak deal that does not contain significant concessions from the Chinese. Doing so will trigger a political backlash and significantly impact his re-election chances. Moreover, Trump’s track record suggests that his motivations are not purely political, and that he holds a core position that China’s rise needs to be curbed.
3. Trade-related uncertainties, uncompelling valuations and rising recession risks all point to a challenging market outlook. A defensive lean in asset allocation is sensible against this backdrop, and we prefer to seek returns from fixed income carry versus equities at this juncture. In particular, equities in Asia excluding Japan are most exposed to trade headwinds and continue to face pressure from persistent US dollar strength.
That said, while recession risk is significant and rising, we believe it is premature to forecast a global recession over the next 12 months as a baseline scenario, and it is more likely than not that the global economy will bend and not break over this period.
Granted, a bad mix of trade policy uncertainties, rising tariffs and supply-chain disruptions easily suggests more downside for corporate confidence, but the global monetary policy easing cycle led by the Fed will have an offsetting and supportive effect. Sentiment in the service sector and consumer confidence, which has been more resilient so far, will also gain support from lower interest rates.
If we benchmark the risks today against history, past recession threats in 1995, 1998, 2011/12 and 2015/6 were all successfully resolved by moderate central bank action. In 1998, the Fed conducted a set of interest rate cuts adding up to 75 basis points against a backdrop of palpable fear, triggered by a rolling series of toxic events: the Asian Financial Crisis, the Russian default crisis and the collapse of LTCM. This was enough to avert a recession.
One issue, however, is that the economic impact of a modern trade war is not fully understood, which means that the risks of policy missteps are significant. Not since the Smoot-Hawley Tariff Act in the 1930s have we seen trade conflict of similar global magnitude, and as the Fed Chairman Jerome Powell said in his speech at Jackson Hole: there are “no recent precedents to guide any policy response to the current situation.”
Disclaimer applicable to recommendation
Given that we are in the mature stages of this economic expansion, the distribution of potential outcomes has a longer tail towards the downside. Even if a recession is not inked in for now, investors should not be surprised by more of the same harrowing ride ahead.
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