During May, global equity markets reacted negatively to a deterioration in trade negotiations between China and US. The Australian market was the only exception, rallying due the coalition election victory. With the global economic outlook dependent on a US-China tariff war resolution, this month we look at how this is impacting financial markets and what it means for investments.
US-China tariff war developments
In May, international equity markets became concerned about the escalating trade war between China and the US. The US accused China of “an erosion of commitments” previously made. It increased tariffs from 10% to 25% on $US200 billion ($286 billion) of Chinese imports and issued notice it was in the process of adding tariffs on an additional $US300 billion of trade.
Oxford Economics estimates that if the 25% tariff is extended to all of China’s exports to the US, it could reduce US economic growth by 0.5% next year. The impact on Chinese growth could be as high as 1.3%. Tensions were further escalated when Washington blacklisted Chinese telecoms giant Huawei.
The US trade policy made further shifts as they enforced an embargo on Iranian trade and announced they would no longer recognise India as a developing country (a status that exempts nations from US tariffs) and threatened new tariffs on Mexican imports.
US & China equity markets reacted negatively
The US S&P 500 Index experienced its worst performance for the calendar year, down 4.9%. China announced retaliatory tariffs on $US60 billion ($83 billion) of US goods. The impact of the trade dispute is clearly having a negative effect on the Chinese economy and the Chinese Shenzhen Index fell 7.7%, while Hong Kong fell 6.9%. Trade dependent Japan also suffered with their market falling 3.4%.
UK & European markets also down
In the UK, Brexit continues to further divide the country, with the Prime Minister Theresa May announcing she was stepping down. The FTSE 100 Index suffered a 4.4% loss for the month. The European wide Parliamentary elections were held in May, with the centralists parties losing ground, but not to the extent some had feared. However, trade tensions dominated most markets with the German DAX falling 4.0%.
Uncertainty over the trade negotiations were a boon for gold, with prices rising to their highest level in more than two months as investors sought refuge in safe-haven assets. Base metals finished mixed, with copper closing at $US263 and Iron Ore rising to $US108 tonne.
Iron ore remains high
The ongoing high price for iron ore is underpinned by the estimated 98 million tonne supply gap left by Brazilian miner Vale following the Brumadinho dam disaster in late January. In addition, China’s environment ministry has ordered mills to target ultra-low emission levels to improve air quality, creating demand for better quality iron ore, which BHP and Rio have in abundance.
Australian equities rally
The Australian share market was an exception, producing a 1.7% gain. This appeared to be largely due to the surprise election victory of the Coalition. The election result removed the threat of changes to capital gains tax, franking credits and negative gearing. Additionally, banks rallied strongly, buoyed by the lack of introduction of another bank levy and some relaxation in home lending regulatory criteria.
A further decline in local interest rates also created a positive impact on the local market. This led to higher dividend paying stocks performing well, with solid returns in Property Trusts (+2.5%), Financials (+2.6%) and Telecoms (+7.3%).
The S&P ASX 200 Index is now up over 11% this year, making it one of the best-performing stock markets in the developed world, with the big four banks, BHP and Rio Tinto the key drivers.
Fixed interest & currencies
Despite the possibility of China retaliating to US tariffs by selling some of its $US1.12 trillion of US Treasuries, the US bond market rallied in May. US Treasuries are still seen as a safe haven in periods of economic stress. Despite growth in employment, US industrial production and retail sales declined. Along with a softening in other economic indicators, market expectations have switched to a cut in US cash interest rates over the next year.
After a 30-month hiatus, the Australian market firmly priced in a cut in official interest rates in early June when the cash rate was reduced from 1.5% to 1.25%. Expectations are now for a second cut by August. Markets are suggesting a 75% chance that the cash rate will be 0.75% by this time next year. Consequently, the Australian dollar closed the month lower at US69.2 cents and the 10-year Government bond yield fell sharply from 1.79% to 1.46%.
Outlook and portfolio positioning in view of US-China Tariff War
The global equity market has finally acknowledged the seriousness of the trade dispute between the two largest economies. Global economic prospects are now very much dependent on a resolution to the dispute and some winding back of tariffs. If this fails to take place over the remainder of 2019, a global slowdown and weaker equity market appears likely.
Conversely, the negotiation of a successful agreement to reverse tariffs, combined with an accommodating monetary policy and no natural end to the growth cycle due to higher inflation, may facilitate an uplift in equity markets.
The outlook for global equity markets is becoming increasingly dependent on a trade deal. This therefore warrants some underweight allocation to equities. Australia is not immune to the potential negative fallout from the escalation in trade protection, given its strong dependence on China for export income.
With interest rates moving to new lows, defensive assets are unlikely to produce attractive real returns well into the medium term. This suggests a strategic allocation to alternative assets to diversify within investment portfolios.
Any advice provided is of a general nature and does not take into account personal circumstances. Any decision to invest in products mentioned here should only be made after reviewing the relevant Product Disclosure Statements. Past performance is not a reliable indicator of future performance. No revenue has been received by Accru Financial Planning as a result of this article.
Accru Financial Planning Pty Ltd is the holder of Australian Financial Services Licence No. 341864 issued by the Australian Securities and Investments Commission.