Remaining flexible and investing thematically rather than geographically are two ways in which Skerritts Wealth Management’s Andy Merricks is preparing for the possibility of an escalating trade war.
The head of investments said the difficulty with geopolitical issues such as a trade war is that there is a chance for both best- and worst-case scenarios to play out – with all in-between also on the table.
As such, it is important for investors to be able to manoeuvre their portfolio accordingly through an active manager – although it’s something that investors may not be too concerned given the growth of passive strategies in recent years.
Merricks said: “If you buy a passive fund you are actually making an active decision to ‘buy everything’, which one supposes that you would only do if you had confidence that ‘everything’ was going up for a long time.”
This was not the case at the start of the year, however, as the global equity MSCI AC World index corrected 9.54 per cent from peak-to-trough.
Performance of index over YTD
Source: FE Analytics
“Markets faltered in February, and again just recently, largely against the backdrop of trade tariffs, first threatened – then real, levied by Donald Trump against his perceived foes and allies, the defining lines between each being somewhat blurred,” he said.
Since then the index has recovered, sitting 4.13 per cent higher over the course of 2018 so far, with Merricks questioning whether investors are too complacent.
As such, it is important to think about investment time frames and whether or not investors have the stomach to weather a market correction/recession borne from a potential trade war.
“If you are an institutional pension fund investing on behalf of thousands of members on a 25 to 30-year time horizon you don’t care a jot. Short term concerns are an irrelevance,” Merricks noted.
“If, however, you are investing on behalf of someone who has entrusted you with their lifetime savings, or who is approaching retirement, or who maybe has accumulated a sizeable ISA pot which will supplement income when no more regular remuneration is forthcoming, then how potentially serious threats to the security of these pots of capital are handled is extremely relevant.”
Merricks said if you fall into the second camp there is an obvious answer as to where to put your capital: nobody truly knows.
The situation of rising tensions between two such global powerhouses as the US and China has never really been experienced before in markets, he argued.
Some may point to the Tiananmen Square incidents of 1989-91, however Merricks said since then China has developed into an entirely different proposition economically and is now viewed as a rival in terms of global trade to the US.
While noting that it is hard to see how China can win a toe-to-toe tariff war with the US – as China’s dependency on exports being significantly higher than the US – Merricks said it is highly unlikely to just “sit back and take it on the chin”.
The Skerritts head of investments said: “If tariffs began to destabilise China internally in the shape of rising unemployment due to manufacturing jobs being lost, they would undoubtedly react.”
This could be in the form of devaluation of the renminbi, something the country did in 2015 causing a flight of capital from overseas investors, although Merricks said the government may have been to have been too timid back then.
He said: “Peter Berezin at BCA Research reminds us that ‘standard economic theory says that a country should always devalue its currency by a sufficient amount to flush out expectations of a further decline’ which is what they failed to do back then.”
However, while this is a best-estimate of what may happen Merricks argued that “anyone who predicts the outcome with any certainty should be treated with scepticism”.
Instead, all investors can do is look for clues as to what might outperform in both a best- and worst-case scenario.
Source: Skerritts Wealth Management
“Looking at the table above, it is clear to see that the US dollar tends to strengthen at such times,” the head of investments noted.
Indeed, the dollar has been the only currency to appreciate in value when the market has worried about a trade war; this will also be as a result of the Federal Reserve’s quantitative tightening cycle. 
“It is virtually impossible to see how emerging markets cannot be adversely affected by a rising dollar, potentially slower global growth and a weakening background for commodities,” Merricks (pictured) said.
“Around 80 per cent of emerging market debt is paid in dollars, while outside of China, emerging market US dollar-denominated debt is back to levels seen in the late 1990s. Potentially, capital outflows from emerging markets simply strengthens the dollar further.”
All equity regions fall in this scenario, while some European bonds offer protection, although there is little else in positive territory.
However, he said that the issue with positioning a portfolio accordingly relies on the fact that a trade war will occur and that it will be severe.
While it has the potential currently, and some may even argue that it is likely, these situations may not happen or play out in the way that is expected.
He added: “If the threat of a severe trade war diminishes and empty rhetoric wins the day, markets will fill their lungs and set racing for a new summit.”
As such, he is investing thematically rather than geographically, making sure that all investments are traded on a daily basis, giving him the ability to change his mind quickly if need be.
“We’ve already identified vehicles into which we can switch should we need to, and we’ve identified currency as a route to safe haven as being more likely to help us steer through any choppy waters than the more traditional haven classes of bonds or gold,” Merricks said.