The China-U.S. trade war has re-ignited and the U.S. Treasury yield curve inverted in March. Offsetting this, global central banks have turned dovish and China’s stimulus package is on the way. The cycle risks make us cautious until there is clarity on the trade-war fallout.


The China-U.S. trade war has re-ignited and the U.S. Treasury yield curve inverted in March. Offsetting this, global central banks have turned dovish and China’s stimulus package is on the way. The cycle risks make us cautious until there is clarity on the trade-war fallout.


China syndrome

Global markets are tracking U.S. President Donald Trump’s Twitter account. His May 5 tweet announcing a tariff increase on Chinese imports triggered the end of the equity market recovery from the late-2018 downturn. The S&P 500® index, which had rebounded 25% from its low on December 24 through May 3, fell 7% over the next month. Equity markets have since bounced back, but the lasting impact can be seen in falling long-term government bond yields, the inverted U.S. yield curve, the slowdown in global trade, and weak global manufacturing surveys.

The case for caution is that trade-war uncertainty is depressing business confidence and international trade. The added concern is that it is happening while global profit growth is slowing. JPMorgan’s tracker of global business capital expenditure is signaling negative business investment spending for the second quarter of 2019 after healthy growth through most of 2018. The risk is businesses could cut back on hiring, which flows through to consumer spending and creates a self-reinforcing downturn.

The trade war’s hard to measure risk is its impact on global supply chains. Modern trade is dominated by the exchange of intermediate goods, which account for around half of the global trade in goods1. The ripple effects of a further trade-war escalation are unpredictable and potentially large.

On the other hand, China’s economic stimulus, global central bank easing, and a trade-war cease-fire could set the scene for a rebound in the global economy later in the year. A number of central banks have either eased policy or made dovish announcements. It now seems likely that the U.S. Federal Reserve (the Fed) will cut rates at least once over the next few months in an attempt to offset against a corporate confidence-led slowdown.

This key to a more positive outlook is for President Trump to back away from his trade threats and focus on his 2020 re-election campaign. That would be logical, given that his re-election may depend on support from Midwest states that will experience the most economic pain from rising tariffs.

President Trump’s actions so far, however, make it unwise to assume he will back down. The re-escalation of the China trade war since May, the additional threats against Mexico and the possibility of tariffs on automobiles (which would harm Japan and Germany) suggest the President intends to continue with his “maximum pressure” negotiating tactics. This uncertainty, along with the recession warning signal provided by the U.S. yield curve inversion and the downtrend in business confidence indicators, keep us cautious for now.

Yield curve inversion – is it different this time?

The most worrying indicator is the inversion of the U.S. yield curve. This has predicted every U.S. recession over the past 50 years, with just one false alarm – the inversion in 1998 amid the Asian economic crisis, the Russian bond default and the collapse of Long-Term Capital Management.

The yield curve inverts when the 10-year Treasury yield falls below the short-term yield. This is a powerful indicator because it implies that bond markets believe the economy will weaken enough to require lower Fed interest rates.

It’s possible the bond market has over-reacted to the trade-war fears and the weakness in global manufacturing and trade data. It may be like 1998 when the threats to the U.S. economy were exaggerated and a small amount of Fed easing set the stage for a further two and a half years of economic growth and market gains.

The combination of Fed easing, China stimulus and trade compromise could mean this inversion is a false signal. The yield curve has been inverted for a relatively short period of time so far. We will take the inversion much more seriously if it persists for a couple more months. For now, it’s a worrying indicator that biases us toward caution.

Historical 10-year/3-month U.S. Treasury yield curve inversions
Date Duration (days) Magnitude (basis points) Outcome
1989 84 -14 Recession
1998 5 -6 False alarm
2000 196 -46 Recession
2007 314 -33 Recession
2019* 23 -14 ?

*As of June 14, 2019, for the yield inversion which started on May 23, 2019.

Asset class preferences

Our cycle, value and sentiment investment decision-making process points at mid-year 2019 to a broadly neutral to slightly underweight view on global equities.

  • We have an underweight preference for U.S. equities, driven by expensive valuation and cycle concerns around the trade-war escalation, fading fiscal stimulus and yield curve inversion. We’re broadly neutral on non-U.S. developed equities. Valuation in Japan is slightly positive and neutral in Europe. Both should benefit from stimulus in China which will help bolster export demand.
  • We like the value offered by emerging markets equities. Regional central banks are easing policy and emerging markets will benefit from China stimulus. It is, however, at near-term risk from the trade-war escalation and the disruption in global supply chains. Near-term caution is warranted.
  • High yield credit is expensive and losing cycle support, which is typical late in the cycle, when profit growth slows and there are concerns about defaults.
  • Government bonds are universally expensive although U.S. Treasuries are closer to fair value than German bunds, Japanese government bonds and UK gilts. The global trade-war escalation and manufacturing slowdown means cycle headwinds have eased slightly.
  • Real assets: Real estate investment trusts (REITs) and global listed infrastructure (GLI) have posted high double-digit returns so far this year. We’re moving back to neutral given that the support from falling Treasury yields is unlikely to be sustained, and earnings supports are at risk from a slowing global economy. Commodities are at risk from the trade war but will benefit from China stimulus. This keeps up neutral on commodities at mid-year.
  • The Japanese yen is our preferred currency. It’s undervalued and has safe-haven appeal if the trade war escalates. The U.S. dollar could weaken once the Fed eases. The main beneficiaries would be emerging markets currencies. The euro and British sterling are undervalued. Sterling, which has more upside potential than the euro, will be volatile around the Brexit uncertainty but should rebound if the UK’s new Prime Minister can secure a deal with Europe, or if a second referendum is called.

1Source: UNCTAD Key Statistics and Trends in International Trade 2018. Intermediate goods are goods or services used in the eventual production of a final good or finished product.

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