Many media and market commentators believe that the ongoing US-China trade war could be one of the largest risks facing the global economy. Invesco analyses the situation and highlights how advisers and wealth managers can use ETFs for efficient asset allocation within clients’ portfolios
While the degree to which relations deteriorate is unknown, many advisers are understandably exploring how best to position their clients’ portfolios amidst the potential economic impacts.
In this article we explore the sectors and asset classes likely to benefit and suffer across a range of trade tension scenarios, why exchange-traded-funds (ETFs) are a useful tool for implementing the sort of nuanced investment exposures that are required for such scenarios, and how an adviser might implement these targeted views. Let’s first consider why ETFs may be an ideal vehicle of choice to express nuanced investment views.
Advantages Of ETFs For Targeted Views
ETFs are unique in many ways. One unique feature is the granularity of exposure many ETFs offer. As most ETF assets are held in broad index trackers, many are unaware of the rich offering that exists in more narrowly-focused funds. These ETFs can be used as “satellite” investments around investors’ core exposures to help fine tune portfolios to specific market or economic investment views.
Take sector-specific ETFs for example. Due to these ETFs’ different sensitivities to macroeconomic factors, geopolitical shifts and other news flow, many asset allocators use sector over- and under-weights to position their portfolios according to their views.
Why might an adviser use an ETF over an actively managed sector-specific fund? Sector-specific ETFs have several advantages over actively-managed funds. First, ETFs provide easy access to a full range of sector exposures, and many passively track indices at lower costs. When compared to achieving the same exposure via an active manager, an ETF may help reduce the need for lengthy due diligence across many different managers. Many sector specific active fund managers are boutique firms that lack a full range of sector funds, and so those investing in these active funds may expend more time and resources performing due diligence.
By using passive replication, ETFs act as tools for pure directional positioning. This may mean less or no unintended conflict between the sector ETF exposure and the positioning or view of the end investor—many activelymanaged sector funds are run as a long/short strategy to increase the opportunity for outperformance, but therefore provide less pure directional exposure.
Another advantage of sector ETFs is breadth of choice. For example, the most actively-traded sector range in the US offers 11 different funds, and, in Europe, there are 18 funds in the most popular sector family. There is also a wide range of ETFs that track less traditional sectors (for example, fintech, robotics, even water) and more thematic indices (for example, exporters and importers).
Lastly, ETFs offer benefits because of how they trade. Sector views tend to be more tactical and short-term than broader regional or asset allocation decisions. By using ETFs within portfolios, it is easier to respond to news quickly, even intraday, and have no mandatory holding periods or pre-defined redemption windows. ETFs are designed to accommodate this type of high turnover trading.
Whether it’s easy access through less due diligence, pure directional positioning, choice or trading, for advisers and clients seeking nuanced investment exposure, granular ETFs, such as sector ETFs, may be the preferred investment vehicle.
Possible Scenarios And Positioning For A US-China Trade War
The ongoing US-China trade tensions provide a convenient framework for examining how portfolios can be adjusted in line with opinions and views. We identified a scale of scenarios:
- Full-scale trade war that also negatively impacts other countries outside the US and China
- No all-out trade war, but a selective application of tariffs to a limited number of products
- China and the US both stand down without any repercussions.
We believe the most likely scenario is not an all-out trade war, but a selective application of tariffs to a limited number of products. This would likely drag on global economic growth and push inflation up in the US as higher imported costs are passed on to consumers. Under this scenario, we expect domestic companies would fare better than exporters. Defensive sectors such as consumer staples, utilities, or healthcare, would likely outperform cyclicals such as banks or technology.
For advisers looking to invest directly into China as a component part of their clients’ portfolios, we believe the impact of selective tariffs on the overall Chinese economy would likely be moderate. Some may view the broad sell-off in Chinese equities during 2018 as representing a fair assessment of this impact, or alternatively as an overreaction and therefore an attractive opportunity to invest.
However, when considering investment in China, it is necessary to select an index. There are several widelyrecognised broad Chinese benchmark indices available through ETFs to choose from. In general, the more concentrated indices, such as the FTSE China A-50 (A-shares), have a higher exposure to more mature, “traditional economy” stocks – in particular financials. These companies are likely to have closer ties with the central government and exhibit more stability and less volatility than many of the smaller companies that are found in broader index benchmarks, such as the MSCI China or CSI-300.
The other two scenarios we identified are the extrema. The worst-case scenario is a full-scale trade war that would negatively impact other countries. This could lead to a global recession which would be particularly damaging for commodities, equities, and emerging markets. At an asset class level, we believe the relative winners are likely to be “safe haven” asset classes such as gold, Treasury bonds, and cash. In terms of equity exposure, the worst-case scenario would favour domestically-focussed defensive stocks. Sectors such as health care, utilities, telecoms, and consumer staples would likely hold up much better than cyclicals. China A-shares in this case would be expected to underperform, in particular the more export-focused industrial and technology sectors would suffer.
At the other end of the spectrum, there is the extreme outcome of a happy ending in which both China and the US stand down without any repercussions. If this were the case, we believe it would be a relief for global equity markets in general, especially for China. Chinese equities would benefit, and the broad sell-off in Chinese equities during 2018 could represent an attractive entry point we believe. Highly cyclical sectors such as basic resources and those most hurt by rising inflation, such as utilities, could be among those that benefit most.
What stands out is that it’s likely the winners and losers would be sharply divided across the scenarios, based on whether they are exporters versus domestically-focused, cyclical versus defensive, and more versus less inflation sensitive. For investors following the markets, new information comes quickly and can have a significant impact on relative sector performance.
ETFs provide a ready toolkit with which to easily realign portfolio exposures – whether to increase exposure to target sectors or reduce exposure to potential underperformers. The granular nature, wide offerings, and flexible trading characteristics of ETFs allow investors to be nimble, especially in preparation for today’s bourgeoning US-China trade war.
Investment strategies involve numerous risks. Investors should note that the price of your investment may go down as well as up. As a result you may not get back the amount of capital you invest.
This document contains information that is for discussion
purposes only, and is intended only for professional investors in
the UK and Qualified Clients in Israel.
Information correct as at December 2018, unless otherwise stated.
This document is marketing material and is not intended as a recommendation to buy or sell any particular asset class, security or strategy. Regulatory requirements that require impartiality of investment/investment strategy recommendations are therefore not applicable nor are any prohibitions to trade before publication.
Where individuals or the business have expressed opinions, they are based on current market conditions, they may differ from those of other investment professionals and are subject to change without notice.
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