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Blog Posts — December 10, 2019

Outlook 2020: It’s All About the Trade War…and a Potential Trump Card for Reelection?

Among the (known) variables driving investor forecasts for 2020, the US-China trade war is number-one. Nothing else—a new UK government or a possible Brexit re-run—comes close. Will it be resolved? If a buoyant stock market is a prerequisite for Trump’s reelection, then a trade-war resolution in 2020 is all but assured.

To quantify the influence of this geopolitical football on global equity markets, we designed two stress test scenarios labeled “Trade War Escalates” and “Trade War Resolution” in the tables below. As the names suggest, the former is designed to show the impact (in terms of expected loss in %) if tensions intensify between the US and China on this issue, while the latter illustrates the likely effects of the signing of a mini-deal and/or a clearly communicated path towards conflict resolution.

Given that this issue has been top-of-mind for investors since March 2018[1] and has seen several reversals in the recent past, we now have ample relevant history to reuse for our forecasting purposes, instead of trying to guess at how things would turn out. We can use the period from May 3 to June 3, 2019 as representative of a collapse in the negotiations and an escalation in the conflict rhetoric, and the period from December 24, 2018 to April 5, 2019 as representative of improving relations, with clear communication that a deal signing was imminent.

The table below shows the predicted loss on a portfolio of US large-cap equities under both scenarios broken down by GICS sectors. Those results highlight the binary nature of this conflict for US investors. The cost of an escalation would be on the order of a 6.8% loss, with the technology sector losing as much as 8%. Other cyclical sectors, such as consumer discretionary, energy, materials, and industrials, would also lose more than the portfolio.

Source: Axioma Risk

A de-escalation in tensions and an apparent roadmap towards resolution, as expected by investors back in Q1-2 of this year, would result in a substantial 24.5% gain for the portfolio. Here again, cyclical sectors and the Tech sector would outshine the portfolio in terms of potential gains. But would this history repeat itself in 2020? Two big caveats on the results from the 2019 resolution scenario. First, the 24.5% gain represents the surge from the post-Q4 2018 market sell-off, which was to some degree caused by fears of consecutive Fed tightening in 2019, not just the escalation in trade tensions. Second, the rise in investor sentiment was based on hopes for a comprehensive trade deal signing and a reversal of all tariffs. We are clearly not looking at either of those outcomes today. The Fed has already reversed course twice on its previous tightening stance and so the market has already recovered some of its interest-rate fear decline. All that is expected now is a mini deal that might prevent additional tariffs from kicking in on December 15. No one is expecting a comprehensive deal or the removal of all existing tariffs at this point. Also note that since the idea of a mini deal was floated in early October, the US market has already risen by 8%. So, given the reduced scope of the current resolution scenario, the now accommodative Fed, and the fact that a mini deal seems to have already been bought and paid for by investors, it will take a lot more than a mini deal for history to repeat itself in 2020 and deliver a 24.5% gain.

In contrast, using the October-November period as representative of a time when investors are hopeful for a de-escalation but less confident than in the Jan-Apr 2019 period that one would indeed happen (having been bitten once before), the portfolio would only gain 6.65%. Given that we have now had three consecutive quarters of negative corporate earnings growth and are forecasting a fourth, this forecast seems a lot more credible than simply replaying a relevant yet circumstantially different history.

But what about investors outside the US?

We repeated the initial analysis on a portfolio of global developed ex-US markets. The table below decomposes those results by country, with the individual expected gain/loss reported for that country as a standalone, not as a contribution to total portfolio loss. Japan is one of the least affected countries in the escalation scenario and the smallest beneficiary of a resolution. In contrast, the UK, HK, and South Korea would be even more affected than the US market in an escalation scenario.

Source: Axioma Risk

Using the October-November history as guide, the world ex-US would only gain 3.4% from a US-China mini deal. No single country would benefit more than the US under a resolution scenario. So, while the US does not seem to have the most to lose from continued tensions, it does appear to have the most to gain from their resolution. As does the Chief Executive standing for reelection.

[1] The timing of the first round of tariffs, though the issue has been on the table since Trump’s presidential bid in 2016.