Stocks and bond yields have both moved lower since early May as trade tensions have escalated. The equity sell-off has been relatively muted, in part because investor perceptions of Fed and Trump "puts" have supported a buy-the-dip mentality.
We caution against relying too much on the Federal Reserve or President Donald Trump taking action in the near term, but the latest developments have still created opportunities.
The market’s belief in the extent of the Fed “put” may be overdone. The S&P 500 rallied last week after Federal Reserve chair Jay Powell said the central bank is closely monitoring the impact of trade negotiations and would act “as appropriate” to sustain the expansion. But Powell’s comments didn’t promise a rate cut; they were more a description of how the Fed conducts policy in a flexible manner.
Markets now imply that the Fed will reduce rates by around 70bps this year and 30bps next year. We believe it would take a recession to provoke this level of rate cuts. This remains unlikely in our view. We believe it’s more likely that we see no Fed cut in the coming months. Given the extent of the recent move in yields and the balanced nature of recent Fed commentary, we have opened an underweight on two-year US government bonds relative to cash.
Trump doesn’t appear to need his “put” yet. The president’s tough stance on trade has not yet dented his chances of re-election in 2020. Meanwhile, his perceived success in using tariff threats to extract concessions from Mexico on immigration makes it easier for the president to claim such hardball strategies are effective. Our base case is for a US–China deal to be reached eventually. We doubt President Trump would want to risk entering the run-up to the election with a slowing economy and weakened stock market, and ultimately we expect him to return to a more conciliatory tone. But economic conditions and market pricing would likely have to worsen to incentivize him to act.
This combination of a positive base case but elevated risks and growth uncertainty is likely to persist. Against this backdrop, our overall six- to 12-month tactical positioning continues to overweight equities, but with a regionally selective approach. In the near term, given downside risks, we would also recommend countercyclical positions.
We believe that US stocks are better placed than Eurozone equities. Historically, Eurozone stocks have only outperformed the US' when the global data on new orders of manufactured goods has been strong, and when the region has been delivering comparable growth to the US. But the new orders component of the composite global purchasing managers' index is at just 52 – barely above the 50 level that separates business expansion from contraction – and has been trending lower.
We also expect the US market to be more resilient: the Fed has more ammunition than the ECB to combat slowing growth should trade tensions escalate, and in our view, concerns about near-term regulatory risk for technology appear overdone. As a result, we have added an overweight on US versus Eurozone stocks.