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A trade-war outcome could blindside investors, Bank of America says



trump xi china trade war 4x3
Trump and Xi Jinping

Contreras/Getty; Greg Baker/Getty; Shayanne Gal/Business

  • The US and China this week escalated their trade
    dispute that has sent investors fleeing from risky
    emerging-market assets. 
  • According to Bank of America Merrill Lynch’s
    cross-asset strategists, investors are only positioned for one
    outcome of the trade war. 
  • They outlined why investor fears may be overblown, and
    a few of their hedges in case the dispute

The trade war
between the US and China is escalating, but many investors may be
caught off guard by one of the possible outcomes, according to
Bank of America Merrill Lynch. 

President Donald Trump upped the ante on Monday when he
instructed the US Trade Representative to impose a tariff on

$200 billion worth of Chinese goods
The latest
tariffs, along with previous rounds on 
billion of imports
, meant that over half of all Chinese
goods coming into the US would be subject to the duties.

China hit back
the following day, announcing tariffs on $60
billion worth of US goods. 

Investors are disproportionately expecting the dispute to
worsen, versus a trade deal that resolves the situation,
according to James Barty, the head of global cross-asset and
emerging-market strategy at Bank of America Merill

There’s proof of this bias in how much better US risk
assets are performing versus emerging markets. In a recent note,
Barty pointed out that non-US equities were underperforming US
stocks by the
most since the financial crisis

Sure, some of the weakness in emerging markets has stemmed
from country-specific issues like the
currency crisis in Turkey
. Some of it also has to do with

rising US interest rates
, a stronger dollar, and a firm
economy that’s supporting earnings growth. 

However, the initial rally of Asian and emerging-market
stocks after Trump escalated the trade war on Monday demonstrated
how much of the news had already been priced in, Barty

Meanwhile, Larry Kudlow, Trump’s top economic adviser, has
said “the
door is open
” for talks with China. And with the Trump
administration eyeing the
midterm elections
and a second presidential term, it may not
want to disrupt the economy’s progress.

“This leaves investors in a quandary because should there
be talks and a turnaround leading to a trade deal (as in NAFTA,
EU/US) then with the Chinese already stimulating their
economy and the US continuing to grow rapidly the prospects for a
decent year of growth in 2019 would look pretty good,” Barty said
in a client note on Friday.

“In that situation, given where sentiment and
positioning are, you could see a big rally in EM and
cyclical assets.”

Such a rally would challenge the majority view, according
to Bank of America’s survey of fund managers, that
emerging-market risk is higher than normal.

Screen Shot 2018 09 21 at 11.30.54 AM

of America Merrill Lynch

These investors are putting their money where their mouth
is. The chart below shows that compared to other major asset
groups, fund managers have the smallest positions in emerging
markets relative to history.

Screen Shot 2018 09 21 at 11.34.05 AM

of America Merrill Lynch

Barty is not oblivious to why investors are cautious and to
the damage a “full-blown” trade war would do. A Chinese economic
slowdown — or even just fears of one — could spook global risk
assets, as happened early in 2016. Also, the Federal Reserve
has flagged
the downside risks
 of a trade war and could focus on
them more if tariffs intensify. 

Barty’s team added to its EM positions over the summer, but
also maintained hedges just in case.

“We feel we cannot own risk without protection given the
trade tensions,” Barty said. “Accordingly we continue to run put
spreads in SPX, UKX and EEM. We also have an AUD/JPY put. We keep
our long SX5E, NKY, RTY vs SPX var as non-US markets are more
vulnerable to trade driven sell off.”

The dispute is already widely being called a “trade war,” which
brings into question what Barty is referring to as a “full-blown”
situation. According to Kate Warne, an investment strategist at
Edward Jones, a trade war becomes full blown when each country’s
objective is not sending a signal or retaliation, but actually
trying to restrict trade. 

“For a trade war, you really need both sides saying ‘what we want
is higher tariffs and to stop this trade,’ and that’s when you
get the escalation,” Warne told Business Insider.

“That’s where you get countries hurting themselves for the
‘benefit’ of less trade.” 

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