â¢ Risk assets have pulled back, but looking beyond the next three months, only two of our seven factors influencing risk assets are negative. We would buy any dip in equities or corporate and EM bonds.
â¢ In our Global Investment Committeeâs assessment, there is an elevated risk of volatility over the summer if a US-China trade deal is delayed, as we expect.
â¢ Within equities, we rebalance away from Asia ex-Japan in favour of the US. We also trim our allocation towards the global technology sector. Within bonds, EM USD government and Asia USD bonds still rank highest in our order of preference, but an increased allocation to Investment Grade (IG) bonds is prudent, in our assessment.
Trade risks escalate again
Over the past month, global equities fell -5.1%. The drop followed a surprise escalation in trade war risks, likely causing markets to reassess the economic outlook. Placing this change in the context of the seven factors we investigated last month (Figure 1), two have worsened as a result of renewed trade tensions, in our assessment, while others are unchanged.
On trade, we see three main scenarios from here. The first is that the US and China still put together a trade deal by the G20 meeting in late June, a positive outcome for risky assets. This was the base case a month ago, but in our Global Investment Committeeâs assessment, the likelihood of this scenario has now fallen to the least likely of the three possible outcomes
A second outcome is the US and China still reach a deal, eventually, but the process is more prolonged over the next few months. This scenario would point to rising volatility in the short term, but an eventual outperformance of risky assets long term. This is now our baseline scenario that we view as most likely.
A third scenario is another wave of tariffs and no deal, an outcome we rank second amongst the three possible outcomes. This could create a negative feedback loop whereby weak equity and credit markets and a stronger USD tighten financial conditions dramatically, further undermining confidence and the economic outlook. Of course, a rising threat of such an outcome could just as easily encourage US-China policymakers to redouble efforts to reach a deal.
The âSell-in-Mayâ seasonality is also a potential negative, as is the signal from falling bond yields. However, other drivers on our checklist remain unchanged. US leading economic indicators and manufacturing PMIs continued to soften, but are above 2013 or 2016 troughs, and services PMIs remain robust. US Q1 earnings surprised positively and earnings revisions in most regions are ticking higher.
Equity technicals appear consistent with near-term consolidation, but not significant weakness. Measures of market diversity are also not flashing red.
In our Global Investment Committeeâs assessment, thus, this leaves us with the conclusion that, in the short term (ie. 2-3 months), a consolidation or pullback may be likely. Long term (ie. 12 months), though, an avoidance of the no-deal trade scenario means risky assets should still outperform defensive assets. In our view, this means it is important to be prepared to buy any dip in equities and corporate/EM bonds.
A temporary period of elevated volatility creates several rebalancing opportunities, in our assessment. Within equities, we see opportunities to trim exposure to Asia ex- Japan equities back to a core allocation following strong YTD gains and rebalance towards the US. From a sector perspective, we close our long-standing preference for the US technology sector, moving it back to a core holding. Within bonds, we would consider an incremental rebalancing in favour of higher quality Developed Market investment grade (IG) bonds.
A period of temporarily high volatility would also create derivative opportunities after what has been an extended period of relatively low-to-moderate volatility. Covered call strategies are one example of this, an approach that tends to outperform long-only strategies during periods of moderately high volatility.
Buy the dip, eventually
Longer-term, though, while it is easy to get carried away by near-term headlines around trade-related event risks, we would be prepared to buy any dip in equities and corporate/EM bonds. Our seven-factor checklist illustrates that only two out of seven factors are negative. Similarly, while the US yield curve (ie. the difference in 10-year and 3- month yields) has once again turned negative, often interpreted as a recession indicator, the lack of confirmation by the leading economic indicator means our assessment of the likelihood of a US recession remains unchanged from last month, at about 30%.
Within equities, we have a preference for the US within an otherwise diversified global equities allocation on a 12-month horizon, given its track record of late-cycle outperformance and continued earnings strength. We also prefer the energy sector, given its ability to benefit from sector-specific drivers. Within bonds, we maintain a slight preference for USD- denominated EM and Asian bonds, given their relative value, mitigation of currency volatility of local currency bonds and the latterâs track record of relative stability.
The USD may also face a more balanced outlook as trade risks offset reducing support from bond yields, though we continue to be on watch for signs that the USD is peaking.