Active is: Adapting to shifts in global trade

How to invest in a time of rate cuts and trade wars

by Mona Mahajan | 14/08/2019
How to invest in a time of rate cuts and trade wars

Summary

The day after the Fed announced its new rate cut, an escalation in the trade war sparked market volatility globally. Investors should be cautious while recognising that similar mid-cycle cuts have been positive for risk assets. Consider staying invested with an active and defensive approach.

Key takeaways

  • The new round of US tariffs on Chinese goods will likely have an outsize impact on US consumers – an area of relative strength in the US economy
  • Barring any unforeseen positive trade news, we expect two more Fed rate cuts this year; these are justified by trade uncertainty alone, in our view
  • Similar insurance-rate-cutting cycles have historically resulted in positive returns for risk assets, but trade and tariff woes add risk for the US and global economies
  • We continue to advocate for active exposure to risk assets, and our focus remains on defensive and “up-in-quality” assets across markets

Trade wars heat up again, giving the Fed another reason to lower rates

Less than 24 hours after the Federal Reserve cut interest rates by 25 basis points – its first rate cut in 11 years – President Donald Trump announced that the US would impose an additional 10% tariff on the remaining USD 300 billion of imported goods from China.

This sudden escalation in the trade war once again caught markets off guard and added uncertainty to the global and US outlooks. The immediate equity-market reaction was severely negative, while the yield on the 10-year Treasury fell below 1.9% and the US dollar weakened.

Expect a big impact on consumers

The additional tranche of tariffs will likely have an outsize impact on US consumers, with nearly 60% of imported consumer goods affected – including apparel, smartphones, electronics, textiles, footwear and toys. US consumers had previously been an area of relative strength in the economy, supported by record-low unemployment, elevated levels of consumer confidence and lower rates in areas like auto loans and mortgages. This new round of tariffs – albeit at 10% rather than the once-threatened 25% – will put some downward pressure on consumers.

Does the Fed need further “insurance” cuts? Yes, we think so

When the Fed announced its latest rate cut, Fed Chair Jerome Powell noted that a key reason was the uncertainty around global trade – and trade became even more uncertain the very next day. Mr Powell also indicated that this would not be an “extended rate-cutting cycle” but he did not rule out further reductions, depending on the outlook for the US and global economies.

Our base-case view is that the Fed will cut rates two more times this year – likely in September and December – barring any unforeseen positive outcomes on the trade front. In our view, trade uncertainty alone provides support for these additional cuts, since tariffs put downward pressure on consumers and the economy. In addition, as Mr Powell noted, there hasn’t been much of a precedent set for trade wars and their potential secondary impact on the global economy. Fed funds futures have now also priced in a 100% probability of a September rate cut, with an 80% probability of 25-basis-point cut and a 20% probability of a 50-basis-point cut.

It is also worth noting that while trade and manufacturing headwinds can certainly hurt the US economy, it remains relatively more insulated than many of its global peers. Nearly 70% of US GDP is driven by domestic consumption, while only about 12% of GDP comes from exports. For comparison purposes, 2018 World Bank figures show that exports in China and Europe made up 20% and 45%, respectively, of GDP.

This cycle may still be relatively short, much like the 1990s

One point that we believe Fed communicated well was that US short-term rates are not currently heading to zero – nor are they turning negative. This is important because negative rates are on the rise, with nearly USD 14 trillion of negative-yielding debt outstanding in bond markets globally – largely in Europe and Japan. Given central-bank easing across major economies, we believe the Fed was right to indicate that US rates will also move lower, but not return to the zero bound.

The best comparison for this “mid-cycle adjustment” from the Fed may be its two rate-cutting cycles during the 1990s; both were “insurance cuts” that resulted in 75 basis points of easing. While the market outcome has generally been positive for insurance cuts, we believe some of these gains have been priced in, given the nearly 17% return in US stocks year to date. While we do not think this pace will continue given the economic uncertainty around trade, markets could grind higher. However, we expect bouts of volatility and some sector rotation in the second half of 2019, especially if the US economy doesn’t head into recession.

We may be entering a “mid-cycle adjustment” period similar to the mid-1990s
Insurance and pre-recession Fed easing cycles since 1981

  Fed funds target rate (%)  
Start End Days Start End Change Type of cut
1/6/1981 15/12/1982 562 20.00 8.50 -11.50 Pre-recession
2/10/1984 19/8/1986 686 11.75 5.88 -5.88 Insurance
19/10/1987 10/2/1988 114 7.25 6.50 -0.75 Insurance
5/6/1989 4/9/1992 1187 9.75 3.00 -6.75 Pre-recession
6/7/1995 31/1/1996 209 6.00 5.25 -0.75 Insurance
29/9/1998 17/11/1998 49 5.50 4.75 -0.75 Insurance
3/1/2001 25/6/2003 903 6.50 1.00 -5.50 Pre-recession
18/9/2007 16/12/2008 455 5.25 0.25 -5.00 Pre-recession
Average 521 -4.61

Source: Allianz Global Investors. Data as at May 2019. 

Market performance during these mid-cycle cuts was quite strong (up over 20% each)
S&P 500 monthly performance from first rate cut

Exhibit 4

Source: FactSet. Data as at 14/6/2019.

Portfolio positioning: remain defensive and move "up in quality"

While insurance-easing cycles have historically resulted in positive returns for risk assets, we believe the new uncertainty around the trade war and tariff escalation adds an element of risk to both the US and global economy. In any given year, we tend to see one to three corrections per year in the form of 5%–10% drawdowns in the S&P 500 Index. In the face of an escalating trade war, we may be facing one such correction now. Yet we still advocate for active exposure to risk assets by focusing on defensive and “up-in-quality” assets across markets.

Equities
We favour a barbell approach in both US and global equities:

  • In the US, we like select cyclical sectors that have done well historically in insurance-easing cycles. This includes areas of technology with secular growth themes and perhaps limited exposure to China – such as mobile payments, cloud computing and cybersecurity.
  • On the other side of the barbell, we favour more defensive sectors like aerospace/defence, REITs and staples, which have all lagged technology this year but tend to perform well in a decelerating growth environment.

Globally, we continue to prefer US equities from a developed-market perspective. We also favour select Asian and emerging-market equities that may benefit from supply-chain disruptions or positive political cycles.

Fixed income
In fixed income, we maintain our preference for “up-in-quality” positioning in both US investment grade and high yield. Given investors’ ongoing hunt for income in today’s low-rate environment, we also see select opportunities in US securitised assets – particularly those exposed to consumers – as well as in convertible and preferred securities. Globally, we see some opportunity in European and Asian high yield, especially for US-dollar-denominated investors.

Alternatives
We remain overweight alternatives, both liquid and illiquid; they tend to be less correlated to both equities and fixed income, providing an appealing source of diversification. We believe areas like absolute return and long/short strategies, as well as private credit or infrastructure debt and equity, remain favourable at this stage of the cycle.



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About the author

Mona Mahajan

Mona Mahajan

US Investment Strategist

Ms Mahajan is the US investment strategist and a director with Allianz Global Investors, which she joined in 2017. As a member of the Global Economics and Strategy team, she is responsible for providing US retail and institutional clients with differentiated investment thought leadership. Ms Mahajan is also a key spokesperson, communicating – both internally and externally – the firm’s high-conviction investment ideas and views from the Global Policy Council. Ms Mahajan was previously a fixed-income portfolio manager, a structured-finance product specialist and a global market strategist at MetLife. Prior to this, she was an emerging-market strategist at Mirae Asset Global Investments; she also worked at hedge fund companies Para Advisors and Ziff Brothers Investments. Ms Mahajan has a B.S. in economics from The Wharton School, The University of Pennsylvania; a B.A.Sc. in computer sciences from the University of Pennsylvania; and an M.B.A. from Harvard Business School.

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Summary

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