There are no clear winners in a trade war, but that doesn't mean an investor's hands are tied.
The damaging effects of higher prices and greater uncertainty have resulted in markets being whipsawed by trade headlines. In our view, the next round of tariffs on $300 billion of U.S. imports from China—even with some of the exclusions announced by the U.S. Trade Representative on August 13—significantly elevates the risk of recession over the next 18 months, should those new and all existing tariffs remain in place for a prolonged period of time (on the order of 9–12 months).
From an asset allocation point of view, we have recommended a gradual reduction of equity risk over the past year, and our client portfolios currently hold a neutral allocation to equities. We have also increased our allocation to defensive assets like high-quality fixed income, hedge funds, and cash.
But what about allocating within equities? Trade headlines are dominating the market in a binary fashion, from "risk on" to "risk off." Additionally, we believe that higher input prices, reduced business confidence, and slower global growth will eventually feed their way into lower overall demand for almost every business. However, shunning all stocks within the cyclical sectors (those like consumer discretionary, industrials, and technology that fluctuate with the ebb and flow of the economic cycle) may paint the equity market with too broad a brush and you may risk missing out on compelling investment opportunities. Our "protectionist playbook" identifies pockets within these cyclical sectors that may hold up better over a 12 month horizon if trade frictions persist, offering places where investors might consider putting their equity capital to work in this time of uncertainty.
Protectionist Playbook
High quality and low volatility—A period of escalating trade tensions and macro-driven market swings calls for a more defensive equity strategy. Generally, stocks exposed to the quality and low-volatility factors (where a "factor" is a set of common traits for a group of stocks, similar to an investment "style") have offered exposure to the equity market but with less market risk, or beta. This is particularly attractive as we expect higher volatility to be with us clear through the 2020 presidential election. High-quality stocks are typically defined by high return on investment, high free cash flow, and low leverage. Low-volatility stocks are, as you would expect, characterized by less variability of returns, which historically have compounded at a higher rate than the broader market over time.
Off-price retail over traditional retail—The consumer discretionary sector is square in the crosshairs of the next round of tariffs, as the remaining roughly $300 billion of Chinese exports to the U.S. heavily comprise previously untouched consumer items like apparel, shoes, and consumer electronics. Within retail, we believe there are still opportunities. Consider the business model for "off-price retail" stores such as T.J. Maxx. The off-price retail model involves purchasing unsold, last season's inventory from traditional department stores and selling it at a discounted price. In the event of higher tariffs and lower consumer demand, traditional department stores will likely be left with a larger amount of unsold inventory, which off-price retail chains can snatch up at better prices at the same time that consumers are shifting down the price ladder and increasing foot traffic through lower-priced stores.
Aerospace and defense over machinery and equipment—Industrial companies that produce machinery and equipment (like Caterpillar) get hit by their exposure to the Chinese economy as well as the U.S. farm industry, both of which are hurt by the trade war. However, aerospace and defense contractors are more tied to federal budgets than global trade, and the passage of a two-year U.S. budget deal earlier in August that increases defense spending, along with the general escalation of geopolitical tensions around the globe, are supportive for the industry.
Tech software over hardware—From a long-term, structural standpoint, we still like tech hardware (including semiconductors) because of the technology revolution that is sweeping across the economy, increasing demand for chips in everything from cars to appliances. However, semis are more cyclical and also more exposed to disruptions in U.S.–China supply chains than are software companies. Companies delivering software and cloud-based solutions should be more insulated from trade skirmishes while riding a wave of cloud spending that we do not see letting up anytime soon.
U.S.-centric over global—Broadening beyond cyclical sectors, we recommend looking for companies obtaining a higher portion of their sales from within the U.S. The trade war has impaired growth in non-U.S. economies more than the U.S. thus far (as the U.S. is a more insulated economy and less export-dependent than the likes of Germany, Japan, and Asian emerging markets). With roughly 90% of the second-quarter earnings season behind us, we have seen U.S. exporters (defined as the top 50% of U.S. companies by foreign sales) deliver revenue growth of 1.0% year-over-year, while those companies more domestically focused have grown revenues more than three times that rate.[1]
The trade situation is extremely unpredictable yet highly impactful for the equity market—a dangerous combination for investors. We assume the tensions and tariffs will remain elevated for the foreseeable future, but we also cannot dismiss the reality that the Trump administration could reduce the tariffs at any time with little more than a tweet, particularly as we head into an election year. This warrants a cautious but not overly defensive approach and, importantly, maintaining a healthy exposure to equities (within a diversified portfolio). We believe there continue to be pockets of opportunity for the long-term investor within this headline-driven market.
Meghan Shue is senior investment strategist at Wilmington Trust and a CNBC contributor.
[1] According to Credit Suisse, as of August 9, 2019.