Investment Strategy Insights: The Impact of Tariffs: So Far, So Little
Economists posit that tariffs are the equivalent of pouring cold water into a nicely warmed pot. At this point in the US-China tariff skirmish, however, the classical cookbook’s rules don’t seem to be yielding the expected results.
In the US, at least, there are few signs to date that increased tariffs on goods from China and Europe have had any measurable overall negative impact on prices or corporate performance. Most US industrial companies are not large net importers from China, and many that are more reliant on Chinese imports are scrambling to rework their supply chains and find alternative sources in other countries. While tariffs produce winners and losers, a small net economic loss in itself, victims tend to be louder than beneficiaries, which is what we witnessed in third-quarter profit reports.
It may be that it will take longer for the impact of higher tariffs to be felt. There are indications that some companies are holding off until next year to raise prices, and some believe the hikes may be substantial. But the degree of pass-through will also reflect the strength of demand. Small-business confidence is at record levels, and while there may be grumbling about tariffs in executive suites, there has been little lobbying pressure from business interests to overturn current levies or to derail new ones. A likely explanation for the US economy’s thus-far tepid response to higher tariffs lies in the twin countervailing tailwinds of last year’s supply-oriented tax cut and initial signs of a productivity upswing.
Current productivity gains are coming from growing business investment that is focused on capability more than capacity. Corporations are investing in technology to offset cost pressures and labor shortages that threaten margins, a trend that at the macro level should lead to continuing disinflationary growth. Corroboration for this view comes from spreads on Treasury Inflation-Protected Securities (TIPS), which have collapsed in recent weeks, signaling few market worries about inflation or the impact of tariffs.
Since the large US domestic market makes it less sensitive to shifts in international trade than export-dependent China and Europe, it’s no wonder that non-US views of tariff skirmishes are decidedly darker. Even before tariffs hit, China’s economy was beginning to stall as a result of its derisking and deleveraging campaign. This weakness is gaining speed, and has already spilled over into Europe and most emerging countries. There is evidence that companies are racing to get exports out of China before the imposition of higher tariffs in January, which would create an air pocket in early 2019.
In slowing economies, trade jitters will inject much more pain than on growing ones.
Conviction Score (CS) and Investment Views
The Conviction Scores shown below reflect the investment team’s views on how portfolios should be positioned for the next six to nine months. 1=bullish, 5=bearish, and the change from the prior month is indicated in parentheses.
Global Economy CS 2.50 (unchanged)
Markus Schomer, CFA, Chief Economist, Global Economic Strategy
We expect strong global growth to continue for the next six to 12 months, despite bearish market sentiment. US growth continues to hold near the 3% trend from the first half. Global manufacturing indicators, while continuing to deteriorate, do not point to a contraction. Meanwhile, labor markets continue to tighten in nearly all developed economies, highlighting the robust consumption backdrop. The two main risks to the outlook abated somewhat last month. First, the Fed gave no indication of a pause, but signaled rates may go down in 2021 to ensure a soft US landing. Second, the latest China data suggest stimulus measures are kicking in, which should help offset continued uncertainty from confrontational US trade policies.
Asia Economy CS 2.75 (unchanged)
Paul Hsiao, Economist, Global Economic Strategy
China data continue to skew negative, with recent reports showing further industrial deterioration. Despite some easing, actual credit creation remains relatively muted as local governments have difficulty finding profitable infrastructure projects. In Japan, business sentiment, especially in the manufacturing sector, continues to weaken on the back of higher fuel costs. The Abe administration confirmed a growth-choking consumption tax hike next year. In emerging Asia, currencies continue as a major theme. We expect more defensive rate hikes from regional central banks, especially those of nations with wide current account deficits.
Rates CS 2.875 (unchanged)
Gunter Seeger, Portfolio Manager, Developed Markets Investment Grade
We have gone from slightly bearish to slightly bullish. Break-evens on US TIPS, which are no longer extremely cheap, have lagged significantly. While outperforming Treasuries by 10 basis points (bps) year-to-date, TIPS are down from 83 bps last month and an all-time high of 130 bps in May. The currency differential and much higher short-term rates have made foreign bonds cheaper than Treasuries after hedging with foreign exchange (FX) forwards, which should mute foreign inflows. Volatility is back. So far in the third quarter the 30-year has been the best performer, followed by the 10-year and the seven-year; the two-year was the worst. But in October, the two-year was on top and the 30-year the worst.
Credit CS 3.75 (unchanged)
Steven Oh, CFA, Global Head of Credit & Fixed Income
Aside from high yield (HY) spreads widening from recent tights, the equity market sell-off has had limited impact on spreads. Performance is being driven largely by duration sensitivity since the volatility was spurred by rates movements, not shifts in economic fundamentals or credit risk concerns. Credit markets also are largely ignoring trade-related risks, Brexit, Italy’s woes, oil shocks, and Fed policy. While near-term corporate earnings expectations remain positive, cost pressures are developing and we may see an inflection in earnings growth in the next 12 months. Within leveraged finance, we continue to favor loans and collateralized loan obligations over high yield. Euro assets have become relatively more attractive. US investment grade (IG) remains attractive on a risk-return basis, but will be driven by rates and supply technicals. We increasingly favor emerging markets (EM) IG despite trade uncertainty. Our longer term fundamental outlook remains positive.
Currency (USD Perspective) CS 3.25 (unchanged)
Anders Faergemann, Senior Sovereign Portfolio Manager, Emerging Markets Fixed Income
Current conditions – strong US economic growth and moderate inflation versus softening growth for Europe and China – favor the US dollar, but developed market (DM) FX volatility remains very low and all major currencies appear confined to very tight trading ranges. Increasing trade tensions, withdrawal of global liquidity, and higher oil prices ought to further support the US dollar, yet so far they are not boosting demand, suggesting market positioning is a factor. The rising yield differential between US Treasuries and German Bunds still has not affected the euro-dollar relationship. Meanwhile, the initial reaction to October’s sharp equity decline was a mildly weaker US dollar, but as equity market sentiment soured further, the US dollar received a safe haven bid. Political risk associated with Italy weighs on the euro for the near term.
Emerging Markets Fixed Income
USD EM (Sovereign and Corp.) CS 2.75 (unchanged)
Local Markets (Sovereign) CS 2.75 (unchanged)
John Bates, Head of Emerging Markets Corporate Research, Emerging Markets Fixed Income
EM flows remained resilient on the back of EM growth and progress in Brazil, Argentina, Turkey, and South Africa. We remain somewhat cautious, partly because EM resilience relies on the US dollar remaining strong and US yields remaining predictable in the face of slowing global economic activity and trade tensions with China. Differentiation among regions remains an important investment driver, with Asia growth having peaked and Latin America’s outlook having improved on prospects for Brazil and Argentina. Gulf states should benefit from higher oil, as should Russia, which could face further sanctions, while Turkey will need to reassure investors it will keep real rates high.
Multi-Asset CS 2.60 (+0.60)
Peter Hu, CFA, FRM, Portfolio Manager, Multi-Asset
While still constructive, we have lowered our CS from 2.0 to 2.6. The divergence between US growth and that of the rest of the world appears to be peaking. We expect the US expansion to continue, but more slowly. Meanwhile, China’s policymakers have made a U-turn and once again are in an accommodation mode to offset the headwinds of overambitious deleveraging and US tariffs. We expect China’s reacceleration will support non-US growth, especially among exporters like EM Asia and Europe, and commodities, especially industrial metals. After a year-long correction, we find EM assets to be attractively valued and we expect their decelerating fundamentals to reverse in nine to 18 months.
Global Equity CS 2.75 (unchanged)
Chris Pettine, CFA, Research Analyst, Global Equities
Third-quarter earnings reports should show waning momentum and weakness in China, autos, semiconductors, and smartphones. The negative impact of higher tariffs remains small, but growing. Product and wage inflation are increasing, but mostly are being passed through. Still, the fundamental backdrop remains supportive. Business activity excluding autos is robust in most markets, and consumer confidence remains high and trending upward. Central banks remain accommodative. Management is generally confident, noting healthy order books, cash flows, and balance sheets. Global equity markets are not overvalued relative to historical norms. The US has moved toward being fairly valued from overvalued, as the S&P 500 forward price/earnings ratio has contracted from 18x to 16x. Selectivity remains key as earnings growth will continue to drive future equities gains.
Global Emerging Markets Equity CS 2.50 (-0.25)
Gustavo Pozzi, CFA, Portfolio Manager, Global Equities
Healthy global growth drives a positive outlook for EM equities despite trade risks. Latin America is enjoying broad, gradually improving growth, and elections in Colombia, Chile, and Brazil show a market-friendly tilt. Inflation is low, employment and consumption are improving, and credit to individuals continues to accelerate. Most EM central banks are likely to increase rates gradually. EM external accounts have improved, as have current account deficits after currency devaluations, commodity price recoveries, and continuing foreign direct investment. Corporates have deleveraged and cash flow generation continues to improve. Valuations versus DM markets are attractive historically. We favor information technology, materials, and industrials over consumer staples, health care, and utilities. We like Poland, China, Mexico, Brazil, and off-index companies versus Taiwan, Thailand, and Chile.
Haibo Chen, Portfolio Manager and Head of Fixed Income Quantitative Strategies
The US Market Cycle Indicator (MCI) slightly improved as credit spreads tightened. Both IG and HY credit spreads were expensive compared with the long-term average. The excess return forecast for EM credit turned neutral from positive, while DM continued to be negative. Among sectors, we like technology, energy, and insurance, as opposed to financials and consumer cyclicals. Globally, our rates model projects a lower level, a flatter slope, and more convex curvature. On duration, our model favors North America and the UK versus Europe and Japan. We project the European slope to flatten the most. On curvature, we expect relatively greater convexity in the US and Canada than in the UK, Japan, and Europe, with the exception of Italy. The rates view expressed in the portfolio was long duration. We are underweight Japan and US durations, close to neutral on UK and Europe, and overweight Canada. On curve positioning, our portfolio remained overweight five-and 20-year durations and underweight other key rate durations.