Emerging Managers, Endowments/Foundations, Institutional Investors

E&Fs Eye Volatility as US/Sino Trade War Threat Looms

Endowments and foundations are addressing concerns about how a looming trade war between China and the U.S. could affect their investment strategies. Volatility in the markets, created by the tit-for-tat tariff pronouncements, coming from both President Donald Trump and Chinese president Xi Jinping, has many investors on edge, with no clear end to the disputes in sight. That said, many are taking a long-term approach rather than reacting to daily market gyrations, and some are looking at the volatility as an opportunity to grab deals.

Phillip Nelson, partner and director of asset allocation at consulting firm NEPC

“Our view is the current trade dispute with China is likely to be a prolonged issue, and investors should expect ongoing tariff discussions with China to be the “new normal.” With that, we expect market volatility for both U.S. and Chinese equities to be elevated relative to recent years, but the trade disputes do not materially alter our long-term views,” said Phillip Nelson, partner and director of asset allocation at consulting firm NEPC.

According to a recent report, NEPC Endowment and Foundation Survey, released by Boston-based consultant, a whopping 78% of the 47 endowments and foundations surveyed said that they are “moderately concerned” about the prospect of a full-on trade war between the two countries, with 11% indicating their level of concern is “very high.” Another 11% say that they are not concerned.

Long-term approach

Cathy Konicki, partner, head of NEPC’s E&F practice group

“Of the 89% of survey participants who said they had some level of concerns about a trade war, most have allocations to China and most of them have it through a broad emerging market strategy,” said Cathy Konicki, partner, head of NEPC’s E&F practice group. The potential trade war plays into their overall concerns about the increased volatility in the market, she said. “In fact, their number one concern is volatility, driven by these types of geopolitical events happening, Konicki emphasized. That said, “They have not made any changes to their portfolios in response to the volatility and are instead choosing to take more of long-term approach,” she said.

One North American endowment with $1.7 billion in assets under management (AUM) that preferred not to be named said that on the equity side, all of its strategies are active, except its passively managed ETFs. Rather than seeing the volatility as a problem, this endowment sees it as an opportunity.  “We think more volatility allows for more opportunity.  We have good managers, and believe that they can do what they say they can do, so they should be able to outperform in those environments,” said the endowment’s portfolio manager.

The endowment also does not let the daily news cycle dictate portfolio moves. “We follow the news flow daily, but it does not impact our decision making,” the portfolio manager explained. “We have a long time horizon, and do not do tactical investing, so we take a more forward-looking approach, looking at longer-term trends, and are not overly concerned with the daily news. We try to decipher the noise from the action, stick to fundamentals, and stay focused on the long run,” he said.

Hideaki Mizuno, the Executive Director, BCA Endowment Foundation

Hideaki Mizuno, executive director of the San Francisco-based BCA Endowment Foundation, also tries not to let talk of trade wars affect him.  “The trade issue is only one of many risk factors, but I do not anticipate it becoming a major risk for healthy economic growth, he said.  For Mizuno, interest rate hikes are where more of his attention is focused. “The biggest risk factor, today, is not really trade or international geopolitical issues, but the speed of interest-rate hikes,” he said. “Higher interest rates are always negative for equities.” he said. “Higher interest rates increase borrowing costs for companies, reduces market liquidity for investors, and slow down consumer spending,” Mizuno said.  “If rates continue to rise, BCA will take a defensive approach and move into shorter duration bonds.”

Taking a wait-and-see approach

Andy Rothman, investment strategist at San Francisco-based asset manager Matthews Asia, which has $35.2 billion in assets under management, said, “I’ve not seen any evidence of a change in strategy and allocation, and that is wise because the odds are that we are not going to see a trade war between Washington and Beijing,” he said. Instead, “Trump has been indicating that he wants to resolve the problem, and if you look at way he is behaving it’s clear that Chinese president Xi Jinping wants to avoid it as well,” he said. Xi has already made several concessions to Trump.  For example, China has cancelled tariffs on U.S. sorghum and announced reductions in tariffs for autos and a number of other consumer goods, as well as plans to better protect intellectual property rights.

The biggest risk factor, today, is not really trade or international geopolitical issues, but the speed of interest rate hikes.

Volatility a long-term trend

According to the NEPC survey, 81% respondents said they believe the recent uptick in market volatility will prove to be a longer-term trend, lasting more than a year. But, 75% of those respondents said that they have made no changes to their portfolio in response to that volatility.

The U.S. equity market has, indeed, exhibited petulance this past year, especially when compared to the past 10 years, when the market was on a mostly upward climb. Konicki attributes the recent volatility to a range of geopolitical concerns, including the rise of populism in Europe and the impact of Brexit. “Those have been a big cause for concern in terms of the move in many countries toward insularism versus a more open global trade,” she said. “Lots of countries are tired of globalism and want to do what’s best internally, which plays into the volatility in the markets. The ever-fluid atmosphere has made it difficult to make quick reactions,” she added.

The North American endowment portfolio manager that spoke on background said he does not execute investments in-house, so does not worry about watching the market on a daily basis. “We delegate it to our partners, our investment managers, and we speak with them on a quarterly basis, so we are not stock picking,” he said.  “We watch daily volatility, but don’t act on it.  We are focused on the next decade more so than the next week, not shifting daily or monthly market moves.”

Investment in China through broad EM strategy

The NEPC survey also looked at endowments’ and foundations’ overall exposure to China. Of those surveyed, 72% said they are investing in China via a broad emerging markets strategy, while 4.25%  are investing in China via both a broad emerging markets strategy and a dedicated China-only investment strategy (e.g. China A-Shares). Exactly 8.51% of respondents said that a China-focused private equity or private debt strategy represents their portfolio’s exposure to China, while another 8.51% said that they have no direct exposure to China. Just 6.4% of respondents said their exposure to China was in another form or asset class.

“We have a dedicated allocation of 10% to emerging markets, including a China portion aggregated through three managers, with each fairly close to the benchmark with not much deviation,” said the North American endowment’s portfolio manager. “We don’t have a China strategy, it’s at the discretion of the managers,” he said.

Mizuno said that BCA Endowment Foundation’s direct China exposure is through an international and an emerging equity fund and neutral exposure, via an index fund. “We still believe emerging markets offer good investment opportunities, so we overweight the sector by a small percentage point,” he said.We are also aware of earnings disappointment risk caused by the trade issues among the US blue chip companies from their business exposure in China. However, the valuation and economic fundamentals also support our overweight position in US equities, as current valuations are at a historical average and fundamentals are in good shape,” he said.

Emerging markets can stand the heat

“We would expect portfolios that have an overweight to emerging market equities to experience a heightened level of volatility during periods when the U.S. and China trade disputes become featured headlines,” said Nelson. “These bouts of volatility represent an opportunity for investors to rebalance and/or increase their exposure to emerging market equities.” Mizuno agrees, noting that “higher return justifies higher volatility.”

“Emerging market exposure is still the highest growth sector globally, notwithstanding the volatility, due to growing populations and a rising middle class that is buying more goods and services,” Konicki observed. “It’s the unknown factors about those markets, such as political risk and currency risk, that still bring volatility to those investments,” she said.

Rothman also concurs. “Even if there is a trade war with China—Trump putting tariffs in place and a response from China—the impact on Chinese companies will not be significant.” That’s because China’s economy is no longer export-led.

We would expect portfolios that have an overweight to emerging market equities to experience a heightened level of volatility during periods when the U.S. and China trade disputes become featured headlines.

“Ten years ago, China’s net exports—the value of exports minus imports—were equal to almost 10 percent of GDP. Today, the figure is only 2 percent,” Rothman said. “The largest part of the economy is the domestic demand part, which now accounts for the majority of economic growth in China. It’s not an export-led economy. The listed universe is also not export-focused. Less than 10 percent of A-share companies, and less than 1 percent of the Chinese companies Matthews holds shares in, are export-focused,” he noted.  “Across all of our strategies, less than 5% of our China holdings have significant exposure to the U.S. market, Rothman added.

Rothman remains very bullish on the country. He calls China “the world’s best consumer story,” with 7% real retail sales growth, supported by 6% real-income growth, low household debt and a high savings rate. “This consumption-driven economy should be fairly well insulated from any trade conflict. So, even if there were a trade war and that results in short-term panic and lower valuations, that would create a buying opportunity for long-term investors,” he predicted.

Going forward, Nelson sees three possible trade war scenarios playing out. “The first is a broad negotiated solution akin to a trade agreement that addresses a multitude of disputes for the U.S. and China. This conceivably would need to include agreement on tariffs, market access in both China and the U.S., intellectual property rights, and availability of U.S. technology. The second is a full-blown trade war between the U.S. and China that severely limits economic access to the other’s markets. We view this as a less likely scenario, as the leaders of both the U.S. and China know the outcome is severe and likely results in a global recession. With that in mind, we think both the U.S. and China are motivated to avoid the trade disputes from escalating dramatically. The third scenario assumes the trade disputes will be a prolonged irritant, but have a minor impact long-term,” he said.



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