Uncertainty and volatility may be in vogue today, but diversification should never go out of style.

Our Top Market Takeaways for the week ending August 9, 2019.

The word on markets

Simmer down

What. A. Week. The latest round of tit for tat in the United States and China’s never-ending trade saga sent markets scrambling at the beginning of the week. On Monday, China said it would stop buying U.S. agricultural goods and allowed its currency to depreciate to levels not seen in over a decade, prompting the U.S. Treasury to designate China a currency manipulator (for the first time since 1994). Spoiler: Risk assets didn’t take the news too well. Monday saw the worst trading day for the S&P 500 (-3.0%) and the MSCI China (-3.5%) since early December. Basically, it was a bleak start to the week.

China’s allowed its currency to depreciate to levels not seen in over a decade Line chart shows Chinese yuan (CNY) per U.S. dollar (USD) from 2008 through 2019. The chart highlights that 7.00 is the psychologically important level for markets. The line has exceeded this level only twice in this time frame, early 2008 and currently.

After the manic Monday, the sell-off simmered down (at least a bit) as some investors swooped in to buy stocks on sale and China’s central bank took action to stabilize its currency (quelling some worries that the yuan would free-fall, more on that in a sec). Heading into Friday, the S&P 500 had recovered from its early-week losses. However, the spike in volatility, a strong rally in gold (which hit a six-year high), and a big move in rates (the 10-year Treasury yield fell to 1.70%, the lowest since 2016) suggest to us that investors are still feelin’ antsy.

Despite frustration in recent days, it’s important to keep it all in context. While the swings in equities may feel pretty significant, the recent level of volatility is actually in line with the historical average (which is why we suggest that the ups and downs shouldn’t derail your plans). On the other hand, the move in bonds has caught our attention—the size of the drop seen in U.S. 10-year Treasury yields over the last four weeks has happened only 3% of the time going back to 2001. While much of the move lower in rates this year has had to do with weaker growth and central bank shifts, the latest leg down seems to be driven by investors seeking protection against an adverse trade war outcome. Read on for our latest thinking on the drama.

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The gloves are off

As mentioned above, U.S.–China trade relations took a turn for the worse this week. China’s decision to allow its currency to break through the 7.00 per U.S. dollar exchange rate was mostly symbolically meaningful, rather than economically significant. Since tariffs have been implemented, the Chinese government has strategically allowed the yuan to fall in a measured way. Why? A weaker currency can help offset the negative economic impact of tariffs (it helps cheapen the cost of Chinese goods to foreign buyers on a relative basis, helping them stay competitive with other exporters). The 7.00 level, however, was previously thought of as the line in the sand beyond which Chinese officials wouldn’t let its currency fall as a good faith measure to the United States. When it happened this week, it sent a message: the gloves are off, and all forms of retaliation are on the table. The United States quickly responded by naming China a “currency manipulator,” a tag they’ve long avoided placing on China.

It seems like any remaining mutual trust between the United States and China has dissolved. This is cause to believe that trade headaches (and associated market volatility) aren’t going away anytime soon. Come September, pretty much every good coming from China into the United States will be tariffed, and an increase in those tariffs isn’t the only way things could escalate. Both camps have tools left at their disposal. The United States could increase sanctions on Chinese companies (like Huawei, for example), add new export restrictions on critical components, restrict Chinese financial institutions’ access to dollar clearing, or try to weaken the dollar. Oy. China could hassle U.S. companies with operations in China, or take more extreme measures like selling U.S. Treasuries en masse. Not great. It’s also possible that we get some sort of truce or even a full compromise in the coming months, but we place a low probability on that happening.

Said simply, politics (not economics) seems to be the driving force behind both countries’ actions. Even if both sides want a deal (after all, they did spend months painstakingly negotiating the finer points of one), escalation has made a deal much harder to achieve. U.S. actions to impose more tariffs and name China a currency manipulator have made it more difficult for Chinese leaders to offer concessions. Point being, it’s now much harder to find a compromise where both sides can save face.

We think this uncertainty is likely to keep markets on edge for the foreseeable future. But this isn’t a new development—investors have been grappling with trade uncertainty since the first half of 2018. While this latest step up in tensions may have been particularly disconcerting for many investors, the last 18 months have proven the value of staying invested and, crucially, staying diversified. Amid a number of risks (such as Fed tightening, slowing global growth, trade wars, etc.), having an allocation to defensive assets such as bonds has helped dampen the impact of market volatility on the downside, while still capturing a good amount of the upside. Uncertainty and volatility may be in vogue today, but diversification should never go out of style.

The right approach seems to be a diversified approach Line chart compares the MSCI World Index, Balanced Portfolio (60/40) and the Bloomberg Barclays Global Aggregate from January 2018 through August 2019. The trajectory of each line shows that, typically, when the MSCI World Index is up, the Bloomberg Barclays Global Aggregate is lower (and vice versa), and the Balanced Portfolio falls somewhere in between the two.

All market and economic data as of August 2019 and sourced from Bloomberg and FactSet unless otherwise stated.

We believe the information contained in this material to be reliable but do not warrant its accuracy or completeness. Opinions, estimates, and investment strategies and views expressed in this document constitute our judgment based on current market conditions and are subject to change without notice.


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