There are three interesting phenomena affecting markets these days, and more often than not the analyzes we see in the media miss important dynamic aspects of those phenomena to the point of reaching conclusions different than ours.

The so-called trade war between the US and China is clearly the most prominent of those phenomena. The G7 monetary policy normalization and how it seems to be affecting emerging markets, is generating fears of general contagion, which we believe are for now misplaced. And, finally, the strength of the US economy is part of the reason for good corporate earnings and the outperformance of the stock market despite other risk factors. On this third phenomenon, the missed dynamics that can produce a continuation of the cycle is has to do with investment and productivity growth, which shows incipient promising signs, and if not disrupted by the trade conflicts could continue to support equity markets higher. Let us elaborate a bit on each of these three phenomena, and how they affect portfolio design.

As the US and China continue to escalate their trade dispute, more and more of the analysis of the potential effects of tariffs becoming more permanent follow simple arithmetics to show that at the end of the day the effects would not be significant. These analyzes tend to show that 10 or even 25% tariffs on what the US imports from China would end up producing only a 0.2% increase in inflation, and a moderate impact on S&P500 earnings (usually around 5% per year on earnings, which in itself would have a moderate impact on PE ratios and such). These calculations are simply static arithmetic calculations, they miss a crucial aspect of most policy decisions (especially taxes and tariffs), which is the effect on incentives and decisions, not to mention the increase in uncertainty. As with most taxes and distortions, they produce changes in economic decisions (production, investment, employment) away from the most efficient outcome towards distorted outcomes, reducing productivity/profitability, and through time reducing investments, consequently growth. Tariffs change the relative prices of goods and inputs, producing changes in economic decisions away from the most efficient outcome, and require wasteful spending in adapting those decisions to the new tariffs scheme. As this game of chicken with tariffs continue, and they need to be factored into economic decisions of global companies (as well as small companies), there would be a tendency to reduce economic growth. Because of this effect, for many economic actors the best decision is to wait, which in terms of investment and production means a negative effect on growth. So far the data is not showing it. But with time it could.

That G7 countries have to normalize monetary policy is no secret. That the Fed is so far the only central bank doing it and expected to continue is not a secret. But, as we said many times before, this is an unprecedented phenomenon, as we had never seen such a coordinated large expansion of central banks’ balance sheet, and the subsequent unwind. There is no roadmap. As rates rise, those most dependent on debt could suffer. This is what is happening with some emerging economies. Argentina and Turkey are the obvious cases in point. The question is whether they are the tip of the iceberg or part of a small group of idiosyncratic cases. We believe reality is closer to the latter, as there is a spectrum of country fundamentals, along which emerging economies have managed to place themselves. But over the last 10-20 years diversity within emerging markets has increased. More countries have established fiscal institutions that allowed them to have credible currencies that keep their value through time, which in turn allowed them to foster domestic debt markets in their own currencies. Those countries have lower debt levels, smaller deficits, and a local market in which to fund those smaller needs. Contagion can happen through at least two channels: one is the channel of similar fundamental problems that ends up affecting a broader group; the other channel is markets themselves, as those investing in emerging economies suffer outflows and need to sell broadly their positions, including in countries apparently less vulnerable. We believe the first channel is not as likely as the second, as we see the majority of emerging economies with stronger fundamentals than Argentina and Turkey. If G7 monetary policy normalization continues to be a gradual smooth process, responsive to the global business cycle, we believe the general outflows channel would not materialize beyond what we have seen so far. This is a risk if there is a G7 monetary policy mistake.

The US stock market has outperformed almost all others this year, which is not very different than what is happening with economic data. Trade disputes is one risk to economic growth and the continuation of good earnings growth, etc. There are other risks on the negative side, not very difficult to identify, including the length of the cycle, etc. But on the positive side there is a phenomenon that is still incipient, which is investment and productivity growth. The post 2008 crisis recovery has been one with low productivity growth, and investment below historical averages. Since the end of 2016, and helped by tax reform and some deregulation, data has shown incipient signs of a break in that low investment low productivity growth rut. This still incipient phenomenon provides for potential to equities beyond next year’s expected earnings.

This is a simple version of the big picture reasons for our portfolio allocation, with equities below average levels, fairly concentrated in the US (with overweights in a couple of sectors), and a large debt allocation with a very strict duration constraint, mindful of vulnerabilities to rising rates. Cash is also above average at the moment. We are satisfied with the results this approach has produced this year.