With markets rallying strongly for much of 2019, patient investors should have made significant gains from equities over the past year. But the trade war raging between the world’s two biggest economies – the US and China – has made picking the right funds and market exposures much more difficult.
The recent performance of US, Chinese and broader Asian equities demonstrates this. Over the year to 1 October 2019, the S&P 500 posted a 7.3 per cent sterling gain, with China’s Shanghai Stock Exchange Composite index up 5 per cent and MSCI AC Asia ex Japan index up 3 per cent. In each of these areas the average active fund has made a slightly better return than the underlying market.
But these gains have come amid significant volatility. When trade war concerns and other worries upended markets in the final quarter of 2018, the S&P 500 fell 12.2 per cent in sterling terms and the Shanghai Stock Exchange Composite index fell 8.9 per cent. And markets and funds directly affected by the trade war have fallen sharply at other points in the past 12 months, including in May this year.
So investors need to pay close attention to both their asset allocation and the funds via which they get exposure to these markets. US equities still make up the biggest proportion of global equities markets and have led global returns in recent years, while Chinese and Asian equities can be a promising source of longer-term gains, albeit with a considerable level of risk. But it is important to look beyond your US, China and Asia exposure when assessing a portfolio’s trade war readiness, because the effects of the dispute may create risks closer to home.
The US and China are the home of a large number of consumers, so are important markets for exporters in particular. Businesses with an international focus could also be unduly hit by any escalation or continuation of the trade war if it dampens consumer and corporate sentiment more widely. This means that equity allocations elsewhere in your portfolio could take a hit in the event of further trade war measures.
Risks closer to home
European equities look vulnerable: much of the region’s growth has been based on the export of goods such as German cars so investors should reassess their allocations in the context of the trade war. Around 20 per cent of European goods are sold to North America alone.
Equity analysts at investment bank UBS noted in May: “Close to half of European corporate revenues come from outside Europe and there is also the feedback loop from a slower global economy and trade on domestic demand. European sectors that are cyclical and exposed to emerging markets such as China include semiconductors, mining and tech hardware.”
Less obvious sectors could also be vulnerable to the consequences of a situation where trade war noises drive uncertainty. For example, the prospect of looser monetary policy in response to slowing economic growth is bad news for industries that prosper in times of rising interest rates. “Although not necessarily directly impacted, banks are likely to be negatively exposed to an escalation in trade wars given the mechanism of lower global growth and lower European Central Bank rate expectations,” added the analysts.
The trade war is also likely to remain protracted, even if it has shown recent signs of easing. Earlier this month the US and China announced a truce: certain tariffs on Chinese goods were suspended, and China agreed to double the amount of agricultural products it buys from the US, to provide open market access to financial services and to make concessions on currency manipulation. The US and China are due to continue discussions in November and, with a US election next year, President Donald Trump could look to further ease the pressures of a trade war on US consumers.
Esty Dwek, head of global market strategy for dynamic solutions at Natixis Investment Managers, says: “We had been expecting this type of mini-deal, and it could lead to further progress at the Asia-Pacific Economic Cooperation (Apec) summit and G20 meeting at the end of November. Mr Trump needs to navigate the trade dispute carefully as data is pointing to some impact on the US economy. As such, we expect the truce to last and most likely the 15 December tariff hike to be suspended as well.”
But a full resolution looks unlikely for now. “We do not expect a grand agreement or a rollback of existing tariffs this year," adds Ms Dwek. "Both sides remain far apart on many thornier issues, and this agreement really only reinforced actions China has already been taking.”
Europe could be at risk even if US/China tensions abate because a resolution of the dispute could involve those two economies upping trade with each other at the expense of other exporters.
“A resolution to the US/China trade tensions is likely to be cheered by markets globally, but there could be a sting in the tail for Europe,” explains Ben Seager-Scott, head of multi-asset funds at Tilney Group. “One of the major factors driving the US is the bilateral trade deficit and it seems all but impossible for this to be addressed by increasing aggregate demand from China. So an increase in Chinese demand for US imports is likely to mean reduced demand for imports from other parts of the world, and Europe could find itself exposed on this front.”
The next trade war
Funds might not have an obvious direct exposure to the trade war, but are still at risk. As table 1 shows, some of the largest funds in the Investment Association (IA) Europe ex UK sector have exposure that is far from insignificant. At the end of September these funds had exposure to Chinese revenues ranging from around 5 to 10 per cent of assets, with hefty exposure to US revenues. A fall in global trade, or a decline in consumer confidence in China or the US, could have a knock-on effect on the companies held by such funds.
Table 1: Large European equity funds' revenue exposure to China and the US
| Fund | China revenue exposure (%) | US revenue exposure (%) |
| Jupiter European | 9.65 | 25.66 |
| State StreetEurope ex UK Equity Tracker | 9.32 | 22.23 |
| BlackRock European Dynamic | 9.61 | 23.58 |
| Fidelity European | 7.98 | 23.87 |
| Invesco European Equity | 5.13 | 13.9 |
| Janus Henderson European Select Opportunities | 10.06 | 22.79 |
| BlackRock Continental European Income | 5.06 | 15.34 |
| Crux European Special Situations | 8.08 | 17.15 |
| Threadneedle European Select | 10.26 | 25.68 |
| Schroder European | 7.02 | 16.01 |
Source: Morningstar Direct as of 30 September 2019
And some analysts believe Europe faces a more direct threat. Earlier this month, the World Trade Organisation (WTO) ruled against the European Union (EU) and in favour of the US over subsidies given to European aerospace group Airbus (Fr:AIR). The ruling authorises the US to impose punitive sanctions worth $7.5bn (£5.94bn) on the EU and some believe it could precipitate the escalation of a spat between Mr Trump and Europe.
“What the WTO ruling means for European exports is probably less important than what it means for international trade relations and US trade policy as a whole,” says Nikki Howes, investment associate at Heartwood Investment Management. “It shows that the US is willing to fight more than one trade battle at once, with the spotlight now being shared by China and Europe. With a parallel grievance on US subsidies for Boeing (US:BA) due to be ruled on by the WTO next year, a new wave of tit for tat could well be about to begin.”
Ms Howes adds that while the WTO-backed levies are small within a broader context there could be a wider dispute in future.
“We are mindful that trade situations like this could escalate quickly, particularly under president Trump’s tenure,” she says. “The current US/China trade issues began on a relatively small scale, with solar panels and washing machines under dispute.”
So investors with allocations to Europe should look closely at the sectors backed by their funds and whether these seem exposed to a turn in global trade.
“At the moment we’re mostly talking about a US/China trade war, but at a higher level that is just one aspect of a broader shift towards greater protectionism, and the risk remains that the US turns its sights on Europe as its next target,” adds Mr Seager-Scott. “Manufacturing and export sectors are clearly most exposed to the global trade war. I would be reluctant to talk about mitigation [of these risks] – rather it is really about which risks you want to be exposed to. You could look to mitigate trade war risks to some extent by taking more of a domestic focus, but the domestic European economy is experiencing its own headwinds due to negative interest rates and the consequent impact on banks, which in turn has a negative effect on credit growth.”
The European economy has looked troubled over the past year, with even Germany stuttering, and the region is not yet showing obvious signs of recovery. In August, the rate of eurozone industrial production rose slightly. However, research company Capital Economics argues that this was “nowhere near enough to offset the previous two months’ declines”, suggesting output for the third quarter as a whole is likely to have fallen sharply.
European opportunities
However, there are still good returns to be made in areas such as these. Adrian Lowcock, head of personal investing at Willis Owen, notes that, with around 400m consumers in Europe, there is plenty of scope for businesses to thrive in the region.
“You have a very large universe, which means there are many opportunities and plenty of industries that have high and sustainable growth,” he explains. “Germany dominates the headlines but there’s more to Europe than Germany, and more to Europe than German car manufacturers.”
This means Europe can boast plenty of leading companies, even if it has what Mr Lowcock describes as an “image problem."
“You have robotics in Japan, and US and Chinese tech, so Europe looks a bit antiquated,” he says. “But that belies some very well established businesses that have been through many market cycles.”
European equities can perform well even amid economic difficulties because markets and economies can perform differently to each other. As of 14 October, FTSE Europe ex UK index was up more than 15 per cent since the start of the year in sterling terms, putting it not far behind the S&P 500.
So domestic European exposure may still merit some inclusion in an investment portfolio. It could provide diversification, given how unpopular European equities have become among many investors, and if you invest in a fund run by a seasoned stockpicker there could still be good returns on offer. Some beaten-up regions, meanwhile, have so far looked less troubled by trade war rhetoric than other areas.
When it comes to the UK’s experience of the trade war, Mr Lowcock notes that a preoccupation with Brexit has meant investors seem largely unconcerned about any knock-on effect for now, even if the UK risks getting involved following its departure from the EU.
“The UK has largely been protected [from trade war concerns] because there are bigger issues around Brexit,” he says. “But what world are we entering [after leaving the EU]? We need to negotiate trade deals with the US and China. Do we get dragged into their battles?”
The international nature of the UK equity market can mean funds invested in this market are exposed to external pressures such as the US/China dispute. Tables 2 and 3 show how some of the largest funds in the IA UK All Companies and IA UK Equity Income sectors are positioned in terms of exposure to US and Chinese revenues. Many have some exposure to China and a hefty indirect focus on the US.
Table 2: large UK All Companies funds' revenue exposure to China and the US
| Fund | China revenue exposure (%) | US revenue exposure (%) |
| iShares UK Equity Index | 11.5 | 24.45 |
| Lindsell Train UK Equity | 8.14 | 23.19 |
| Invesco UK High Income | 3.32 | 13.81 |
| Liontrust Special Situations | 9.41 | 25.39 |
| Evenlode Income | 10.11 | 31.48 |
| Merian UK Mid Cap | 2.74 | 18.68 |
| LF Woodford Equity Income | 0.86 | 12.03 |
| Fidelity Special Situations | 4.95 | 21.94 |
| Majedie UK Equity | 6.73 | 19.57 |
| Invesco Income | 3.45 | 13.89 |
| Investec UK Alpha | 8.73 | 29.35 |
| Jupiter UK Special Situations | 7.82 | 21.94 |
Source: Morningstar Direct as 30 September 2019
Table 3: large UK Equity Income funds' revenue exposure to China and the US
| Fund | China revenue exposure (%) | US revenue exposure (%) |
| Artemis Income | 7.71 | 20.51 |
| Threadneedle UK Equity Income | 7.89 | 24.95 |
| Trojan Income | 7.59 | 28.31 |
| JOHCM UK Equity Income | 7.69 | 10.97 |
| Schroder Income | 10.55 | 15.15 |
| Royal London UK Equity Income | 8.03 | 20.72 |
| Jupiter Income Trust | 9.16 | 22.74 |
| Marlborough Multi Cap Income | 3.74 | 11.97 |
| BNY Mellon UK Income | 8.47 | 29.71 |
| Man GLG UK Income | 8.92 | 13.13 |
Source: Morningstar Direct as of 30 September 2019
Trade war funds
Several funds have succeeded in slowly and steadily extracting returns from Europe via domestic-facing companies in the past.
BlackRock European Dynamic (GB00BCZRNN30) has exposure to revenues in China and the US, as Table 1 shows. But the fund tends to invest differently to many of its peers by focusing on companies with medium to long-term earnings power greater than that of the market, as well as turnaround situations. Manager Alister Hibbert takes a flexible approach in terms of the size and type of companies he can invest in, although the majority of the fund is currently invested in large-caps. The fund struggled in 2018, but has tended to come out ahead of its peer group: it has beaten the IA Europe ex UK sector average over one, three and five years to 14 October.
Miton European Opportunities (GB00BZ2K2M84) has a shorter track record of around four years, but its managers have consistently generated strong returns by picking businesses based on their fundamental appeal rather than by an assessment of the broader economic backdrop. They look for companies with strong leadership that can grow revenues via a strong competitive advantage. They pay little attention to shifts in the macro picture.
Funds with less stellar short-term track records might also be worth consideration. Mr Lowcock suggests Artemis European Opportunities (GB00B6WFCR53), which has trailed its peers over one year, but fares better over longer periods. Morningstar analysts noted in late 2018 that the fund’s approach is relatively straightforward – its managers buy quality companies that produce high returns on invested capital. But they also said that it is “applied well” by managers Mark Page and Laurent Millet, who filter down potential holdings from a proprietary database of stocks.
Funds with a focus on smaller stocks in particular can provide exposure to domestic-facing companies. A smaller companies fund that has stood out from its peers is Barings Europe Select Trust (GB00B7NB1W76). It has outperformed the IA European Smaller Companies sector average over one, three and five years and backs overlooked companies with strong fundamentals, or what Mr Lowcock describes as “unrecognised growth”. The fund has a good level of diversification, a useful attribute in view of the higher-risk nature of its investment universe, with 91 holdings at the end of August.
A fund with the ability to go down the market cap spectrum with a greater level of flexibility is Marlborough European Multi-Cap (GB0001719730). It can invest in mega-caps, although at the moment much of its exposure is to small and micro-caps.
Mr Seager-Scott favours TM Crux European Special Situations (GB00BTJRQ064) because of its ability to "add value through the cycle". It invests across the market cap spectrum and, at the end of August, 40.6 per cent of the fund's assets were in companies larger than €10bn (£8.71bn) by market capitalisation, with nearly half of its assets in companies with market caps between €1bn and €10bn. The fund has around 60 holdings and can be high risk, but has delivered strong long-term returns.
For UK exposure Mr Lowcock suggests Schroder Recovery (GB00BDD2F190). This fund has struggled in recent years, but much of this is due to its value investment style and domestic-facing UK assets being out of favour. But Mr Lowcock argues that UK domestic-exposed assets could experience a resurgence in performance when a Brexit outcome emerges.
“Much is factored into the price so can it get worse?” he says. “The answer is yes but the value [on offer] is appealing.”
Fund performance
| Fund/benchmark | 1-year total return (%) | 3-year cumulative total return (%) | 5-year cumulative total return (%) | 10-year cumulative total return (%) | Ongoing charge (%) |
| Artemis European Opportunities | -0.69 | 27.69 | 64.67 | 0.77 | |
| Barings Europe Select Trust | 1.08 | 31.33 | 95.01 | 225.06 | 0.7 |
| BlackRock European Dynamic | 3.2 | 40.2 | 82.34 | 202.09 | 0.92 |
| Miton European Opportunities | 7.47 | 58.95 | 0.94 | ||
| Marlborough European Multi-Cap | -2.41 | 25.99 | 97.84 | 134.85 | 0.82 |
| Schroder Recovery | -5.61 | 19.37 | 29.47 | 135.16 | 0.84 |
| TM Crux European Special Situations | 0.25 | 20.79 | 72.33 | 0.73 | |
| EMIX Smaller European Companies index | -2.42 | 23.48 | 64.41 | 144.59 | |
| FTSE All Share index | 2.68 | 21.69 | 38.89 | 121.04 | |
| FTSE World Europe ex UK index | 6.35 | 33.12 | 59.31 | 114.58 | |
| IA Europe Excluding UK sector average | 2.15 | 26.86 | 55.6 | 111.12 | |
| IA European Smaller Companies sector average | -5.43 | 22 | 69.97 | 169.36 | |
| IA UK All Companies sector average | -0.03 | 19.91 | 36.57 | 121.39 |
Source: FE Analytics as of 30 September 2019
