Are Washington and Beijing really at each other’s throats, or engaging in some sort of non-violent martial arts? We think it’s the latter and advise to keep calm for the moment. Naturally, many investors are wondering what to do about their emerging-market stocks. While the row may continue for months or even years, the conflict can be resolved. Chinese shares may be down but not out, so now is a good time to take a closer look.
Being bottom-up investors, we always love to see action from up close. Storms may rage, but unless they have a noticeable impact on the companies we follow, we aren’t overly worried. Therefore, despite the escalating trade row between Washington and Beijing, our portfolio of Asian stocks, including Chinese ones, remains unchanged for now. We believe there is currently no reason to take out risk, or decrease the weighting of emerging-market companies. While the antagonists have taken their places in the fighting arena, a resolution is still possible, in our opinion. That said, just when this might happen is anybody’s guess.
Trade tensions remain the biggest risk factor for emerging-market equities (see also our quarterly market outlook). Investors were probably a bit too sanguine regarding the outcome of negotiations between the US and China at the beginning of the year. This optimism fired up financial markets, despite ongoing negative earnings-per-share revisions – analyst have lowered their earnings forecasts by 10% year-to-date.
Martial arts is about posturing and keeping your nerve, as in a game of chicken. At first sight, Washington is in a good position to apply maximum pressure on its rival. Being the world’s foremost consumer, the US is the brawnier guy in the face-off and can slap punitive taxes on hundreds of USD billions of Chinese imports it hasn’t targeted so far (see chart). But whether Beijing will blink remains to be seen. It can shirk a direct hit, for example by taking additional and more significant steps to stimulate its economy. The Chinese central bank recently loosened its monetary policy. Now, the authorities could start pumping liquidity into the banking system, increasing infrastructure spending, and boosting private consumption.
In our market outlook, we said that trade tensions are likely to continue for months or even years. We believe that the longer the uncertainty lasts, the bigger the impact on company fundamentals will be. However, it’s also true that both parties need an agreement at some stage to cope with domestic issues such as sagging economic growth in China, and presidential elections in the US. Moreover, stock markets would suffer if the squabble got out of hand, a scenario that would spell trouble for both parties.
According to UBS strategist Niall MacLeod, market prices currently more or less reflect the midpoint between a full-on trade war and an amicable resolution. Thus, it is difficult for investors to take sides, MacLeod says. Staying put and waiting for the situation to develop one way or another can be a short-term strategy. Eventually, investors will need to move. For example, they may look at valuation. Chinese stock prices have come down so much that the valuation is getting attractive and the downside seems limited – the caveat being of a full-blown trade war, of course.
What does it mean for us? We stick to our investment strategy, focusing on businesses with company-specific earnings drivers and a limited sensitivity to macroeconomic events. As we have done over the past few years, we concentrate on leading companies that are likely to grow the return on invested capital (ROIC), and whose valuations we find attractive. The recent correction in emerging-market equities might also be an opportunity to start looking at high-quality stocks again. This may be a sound strategy to avoid being drawn into the fight between the US and China.