It appears the spell of ultra-low volatility cast over the global equity landscape during the past 12 to 18 months has now been broken.
An escalation in trade tensions between the US and China has been the chief catalyst for the most recent broad-based equity decline. Given the levels of uncertainty the proposed tariff threats have introduced, the key question from an investment perspective is whether the conflict will remain relatively contained or intensify into a genuine and sustained conflict.
Despite the continued exchange of tariff threats, there is still a window of opportunity where both parties can negotiate and seek a more agreeable outcome. The United States Trade Representative’s detailed list was only published two days ago, and the public has been given a month to review and comment. Reports US Treasury Secretary Mnuchin is negotiating with China have provided some degree of reassurance to investors.
Should upcoming US midterm elections be a strong factor in President Donald Trump’s decision to initiate a trade war with China, a victory through extracting negotiated concessions – as opposed to an all-out trade war – will do no harm to his campaign and should be the preferred outcome.
Risk of continued escalation
However, there is a risk of tensions further escalating between these two global powers countries competing for supremacy and it could last longer than most investors expect. The US attitude towards China has turned decisively more confrontational in recent times, reflecting the fact Trump views China as a strategic adversary.
Negotiations may stall, or worse, collapse – leading to the imposition of various alternative economic and political tools to gain a perceived upper hand. These may include, but are not limited to, fines, the cancelling of existing free trade agreements, anti-trust investigations and the boycotting of products.
Historical precedents do not lend themselves well to a positive outcome. The US-Japan trade conflict, involving quotas on imported Japanese cars in the 1980s, lasted the better part of an entire decade. This is despite Japan being a strategic ally to the US.
In terms of US posturing, The Economist compares the current threat posed by China as far bigger than the combined military and ideological threat posed by the Soviet Union during the Cold War, as well as the threat posed by Japan’s technological prowess in the 1980s.
Avoid short-term forecasts
During periods of heightened market stress, elevated volatility and political tension, we do not want to be making short-term forecasts. Rather, we rely on the high level of rigour and discipline underpinning our quantitative decision-making framework in allocating capital and managing risk in China. Our China market model seeks to provide timely buy and sell signals, on balance, through cycles.
With the return of volatility and accompanying choppy markets, the model has been busier than usual, generating a fresh ‘bearish” signal on 24 March. Our stock selection model seeks to identify and invest in the most attractive 20% of companies in the MSCI China universe. As of now, the model favours domestically-focused, cyclically-geared China exposure, with a focus on consumer discretionary, banks and real estate companies.
Additionally, our Ashburton Chindia Equity Fund implemented a protection strategy – in the form of Hang Seng China Enterprises Index put options and VIX call options – in early February and this remains in place today. The objective is to dampen short-term volatility and reduce the prospect of further downside. We are also holding approximately 8% cash in our portfolio, which we anticipate deploying into stocks at more attractive levels.
Craig Farley, co-manager of the Ashburton Chindia Equity fund