The Complex Effects of a Trade War
The policy conundrums that have dominated headlines aren’t going away soon. In particular, the Trump administration’s on-again, off-again approach to tariffs has left import-dependent US firms susceptible to volatile price swings, while exporters around the world also feel the effects. Many companies are struggling to advance investment plans while the tariff regime remains fluid. But uncertainty might ease if a more systematic approach to tariffs takes root, which could quell investor anxiety, despite concern about the economic fallout of a trade war.
Trade strains and geopolitical risk, from hostilities in Ukraine and the Middle East to China-Taiwan tensions, have threatened to rekindle inflation and muddied the interest-rate outlook. During the first quarter, the US Federal Reserve and Bank of Japan held off on monetary easing, while the European Central Bank cut its benchmark rate 50 basis points to 2.5%—near its long-term target.
For economies and companies, the outcomes of a prolonged trade war will be complex. For example, even Trump has acknowledged that the US could face a recession. That said, the US economy isn’t particularly trade-sensitive, and some companies are more tariff-resistant than others, depending on their industry and operational footprint. Some global companies with US operations might even benefit from tariffs. Examples include European and Japanese electronics manufacturers and consumer goods companies with a large US manufacturing presence.
Expanding Investment Horizons
Investors, too, face complicated challenges with policy uncertainty at a near record high while equity markets broaden. We think the time is right to reevaluate style and regional exposures, particularly as many investors became overweight US growth stocks in recent years because of the Magnificent Seven’s prior dominance.
Defensive equities could add breadth and fortitude. By investing in high-quality stocks with stable trading patterns, a defensive strategy can help reduce volatility created by political, technology and macroeconomic risks. Value stocks offer diversification and still trade at deep discounts to growth stocks. While value stocks are perceived as vulnerable to economic cycles, we believe investors can find undervalued stocks with attractive free cash flows and business attributes that can drive earnings, even in a more sluggish economic environment.
Regional diversification deserves attention. European equities may finally be finding their footing, even as the Russia-Ukraine war remains an ongoing risk. Equity valuations in Europe are still attractive versus US peers, and the average European company beat consensus expectations by 3% during fourth-quarter earnings season. There are even signs of a reversal in outflows from European stock funds over the last three years. Selective investors can find European companies with consistent earnings growth and quality businesses that are more resilient to regional macro and geopolitical risks.
Emerging markets are also showing signs of life and offer hidden opportunities. Some of the biggest players in the global artificial intelligence (AI) supply chain are based in emerging markets. Earnings estimates are trending upward across the developing world, which accounts for 90% of the world’s population and roughly half of global GDP. And our research shows that missing out on an EM recovery could be costly for investors.
Is a Realignment of Earnings Underway?
Recent shifts in equity return patterns call for a closer look at longer-term earnings trends. Over the last 15 years, US corporate earnings growth has outpaced that of non-US companies, represented by the MSCI EAFE Index. However, before 2010, that wasn’t always the case. In fact, our research shows that in three of the four decades since 1970, non-US earnings exceeded US earnings (Display).
