A prolonged trade conflict poses risks to margins and sales

Investment Policy, June 2019

A prolonged trade conflict poses risks to margins and sales

With valuations remaining on the high side, equity markets are currently exhibiting greater susceptibility to profit-taking against a backdrop of an escalating trade conflict between the US and China. Should the trade uncertainties persist, there will also be an increasing risk of investors scaling down their equity allocation due to rising economic risks, as the global economy is not looking especially strong at the moment. Support from central banks remains crucial. 

Discussions in the financial markets are now above all revolving around the resurgence of the US-China trade conflict. The most important point here is simple enough – the global economy, which has been weakening for months, is quite vulnerable to any increased uncertainty about growth in trade. Even prior to the recent announcement of higher tariffs, business surveys of industrial activity both in the US and China had been disappointing the (not very high) expectations of analysts. As uncertainty over future economic development continues to rise, above all in China, corporate investment could be postponed and production growth could slow further. Although employment in the US and parts of the EU is actually robust, this could change if companies start to expect a downturn in growth. And any such change would jeopardise growth in consumer spending. Moreover, higher consumer prices via tariff increases would weaken consumer sentiment. Economic risks of an escalating trade conflict should not be underestimated, particularly for the emerging markets.

Equities
With companies having poured so much cold water on analysts’ expectations of their first-quarter figures, the results themselves managed to surpass these low expectations to some extent. However, the days of US companies being able to exceed earnings expectations as a routine development are over for now. In Europe, company results for the first quarter failed to exceed analysts‘ expectations, particularly with respect to sales growth. This reflects the negative impact of a European economy that is weaker than its US counterpart. By contrast, the global healthcare and technology sectors unveiled above-average results compared to analysts’ predictions. However, both these industries face their own challenges. For healthcare, the imminent start of political campaigns for the 2020 US elections poses a challenge, as both US political parties have been critical of the high prices of pharmaceutical products. For technology companies, above all those in the US, a further escalation in the trade conflict represents a significant risk. Due to tariffs, these companies are threatened with higher prices for imported components, and such additional costs – similar for consumer goods – can hardly be passed on to the consumer in their entirety. Therefore, the historically high profit margins of US companies are now in jeopardy. What’s more, a further escalation of the trade conflict could potentially disrupt supply chains, which would lead to production cutbacks and thus reduce not just profit margins but also sales growth. But it is the emerging markets that are most affected by further trade dispute uncertainties. Why? On the one hand because China, which is the most likely candidate for an economic growth slump, has the highest weighting in the MSCI Emerging Markets Index. And on the other because currency risks – triggered by capital outflows from emerging markets – are a very real threat, particularly if China allows its currency to depreciate further. 

 

Correction risks are a threat for the emerging markets in particular.

Gérard Piasko, Chief Investment Officer

Bonds
For some months now, the bond markets have been benefiting from the slowing of economic momentum. While higher tariffs could push up US inflation by perhaps 0.25% or so, weakening economic growth can be expected to prove a drag on inflation. This is a trend we see, both in the US and in Europe. Corporate bonds have been benefiting from the quest for yield ever since the yields on government bonds started to fall again. It is also helpful for the majority of bond segments that net issuance activity is currently low compared to previous periods, which is reducing bond supply. A further support for fixed-income markets comes from the big central banks. The Federal Reserve, the European Central Bank and the Swiss National Bank have all made it clear that they are planning no interest rate rises for the time being.

Currencies
The phase of weakness that we predicted for the euro back in January – and acted on at an early stage – is continuing. There are three reasons for this weakness. First, economic growth in Europe has not strengthened, despite analyst expectations. Second, the interest rate differential between the euro and the US dollar is an obstacle to any lasting euro upward trend. The monetary policy stance communicated by the ECB has confirmed this on numerous occasions over the last few months. Third, technical analysis shows that below the level of 1.1280 the EUR/USD currency pair remains susceptible to a decline towards 1.10. The behaviour of the EUR/CHF rate is for the most part dictated by the relative strength of the euro compared to the US dollar, although in phases of general risk aversion the Swiss franc can strengthen against the greenback. Fluctuations around 1.02-0.98 are therefore possible.
 
Commodities

The commodity markets currently present a mixed picture. Gold could benefit from geopolitical uncertainties – and not just from tensions between the US and China but also between the US and Iran, following the former’s decision to send an aircraft carrier to the Persian Gulf as a warning. However, the US dollar‘s strength against the euro, the pound and the emerging-market currencies can be expected to limit the upside potential of gold. Industrial metals, which are heavily dependent on Chinese demand, continue to react sensitively to newsflow in connection with the trade dispute. Where oil is concerned, a number of different factors are maintaining a certain price equilibrium. Economic risks could have the effect of holding back growth in demand, particularly from China. On the other hand, following the renewal of US sanctions against Iran, there are also significant risks to global oil supply. Thus commodities are likely to trend sideways generally and exhibit greater volatility.

Gérard Piasko

Gérard Piasko

Gérard Piasko is CIO and head of the investment committee of private bank Maerki Baumann & Co. AG. Before he was for many years CIO of Julius Baer, Sal. Oppenheim and Deutsche Bank.

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This publication is intended for information and marketing purposes only, and is not geared to the conclusion of a contract. It only contains the market and investment commentaries of Maerki Baumann & Co. AG and an assessment of selected financial instruments. Consequently, this publication does not constitute investment advice or a specific individual investment recommendation, and is not an offer for the purchase or sale of investment instruments. Maerki Baumann & Co. AG does not provide legal or tax advice. In addition, Maerki Baumann & Co. AG accepts no liability whatsoever for the content of this document; in particular, it does not accept any liability for losses of any kind, whether direct, indirect or incidental, which may be incurred as a result of using the information contained in this document and/or arising from the risks inherent in the financial markets.

Editorial deadline: 24 May 2019

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