Iran and China — different risks require different strategies

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Updated: 13 January 2020
  • The US-China trade negotiations and US-Iran conflict continue to play on the mind of investors, but equity markets have seen a lull in events as a sign to break to new highs.
  • The bull run buying spree marks the total risk being perceived to be lower, but the twist is that each of the two risks bring with them very different consequences.
  • A new analysis by Bespoke Investment Group highlights how positive news relating to trade talks could favour European and Rest of World stocks.
  • In contrast, a flare-up in the Gulf would favour US stocks.
  • Enhancing returns requires getting the balance right in terms of portfolio construction.

 

Despite market buoyancy, the two main geopolitical risks hanging over the global markets continue to threaten a general market sell-off. While the US-China trade talks and US-Iran conflict may currently be smouldering rather than ablaze, investors and traders are being forced to fight a battle on two fronts. Whichever of the two situations deteriorates first, or most, will determine which asset groups are hardest hit.

 

Iran

The US-Iran conflict has also dropped from the headlines. The rocket salvos each party fired currently mark the peak of recent tensions.

Irwin Seltzer of The Sunday Times described the situation as one where “both Trump and the ayatollahs having found an off-ramp on the road to war” (source: The Sunday Times).

Underlying issues remain, not least Iran’s potential to develop nuclear weapons. The leaders of Germany, France and the UK have on Monday expressed their desire to stand by the Iran nuclear deal and defy a call from President Donald Trump to abandon the 2015 pact. However, the topic moves at a glacial pace compared to the instant impact caused by such things as a wayward missile downing a civilian aircraft.

Source: CNBC

 

It could be that both the US and Iran favour a period of calm. Iran’s aim of extending its influence in the region is based on subterfuge and the US administration appears ready to continue with its stated aim of withdrawing troops from the region. Tehran’s immediate response to the killing of General Soleimani was relatively restrained but sufficient in size to allow them to be seen as standing up to ‘The Great Satan’. US President, Donald Trump, can hope that his presidential campaign positions him as the commander-in-chief who brought (some of) the troops home.

 

 

Phase one

The US and China look set to sign off on phase one of their trade deal on 15th January. The text is expected to cover the three major points of contention, including, tariff relief, increased Chinese purchases of US agricultural goods and changes to intellectual property and technology rules.

Source: Reuters

 

For the markets, this glass is definitely half-full rather than half-empty and President Trump has declared he’s ready to start discussing phase two “right away” (source: Fox Business).

 

 

Favourable wind

If the Middle East remains calm and the US-China trade talks continue to make progress, then Bespoke Investment Group tips European and rest of the world stocks to outperform US-listed names. As the old adage goes, a rising tide lifts all ships — it’s just that non-US markets may perform better.

A fall in oil prices, reduced trade tariffs and the absence of military distractions would benefit trade volumes and the global economy, but Europe would benefit to a larger extent than the US.

Exports from the eurozone account for 46% of the region’s GDP. The equivalent figure for the US is only 12%.

In addition, Europe and Asia are particularly exposed to oil prices. India is the world’s third-largest consumer of crude oil and the International Energy Agency (IEA) forecasts that it will move past China to be the second largest by the mid-2020s. Its consumption is estimated to hit 6m barrels per day by 2024, compared to 4.4m barrels per day in 2017. It ships in 65% of its required supply through the potential flashpoint of the Straits of Hormuz.

The US, in contrast, is a net exporter and any hike in prices could benefit its oil & gas sector as much as it hits consumer spending.

 

 

Convergence

The report released by Bespoke Investment Group does well to mark out the potential triggers of non-US equities outperforming US-listed stocks, but this happening would mark a change in direction for a well-established long-term trend.

The past decade has seen the performance of US stocks out-strip global equivalents.

Source: CNBC

 

The report picks out Chinese GDP growth as a potential catalyst for the two asset groups to stop diverging and actually converge. The non-US firms that are skewed towards export markets — especially China — will benefit to a greater extent if China finds the trade deal an agreeable tonic. Mark Luschini, chief investment strategist at Janney Montgomery Scott said:

“If China merely stabilizes its growth from the deceleration that it’s had the last couple years, that’ll go a long way to putting a positive impulse into these equity markets.”

Source: CNBC

 

 

Dollar base

Traders might also look to squeeze extra returns from relative forex strength. Whilst hedging the forex element of US stock positions is possible, naked positions would see the total trade P&L factor in currency as well as stock price moves.

TradingView user, Ccnnn123 is not alone in seeing the potential for dollar weakness:

Source: TradingView

 

US denominated traders going long on Euro priced stocks could profit from the equity price rising and, or, the dollar weakening. The US currency has shown recent strength against the basket of global currencies due to its role as a safe-haven asset. If geopolitical risk were to be reduced, then that could see a sell-off of USD.

Those monitoring the situation and considering the different nature of the risks involved have one final point to consider. Historical data is full of instances where the economy and the markets have been proven to be distinct from each other. Strong fundamental data doesn’t necessarily follow through as strong stock markets, and vice versa.