If President Trump is trying to etch-a-sketch his name onto the S&P 500 chart, investors are not going to be able to trade around it. We recommend not making major changes in portfolios at this stage, and staying invested. But given that only the president himself knows how far he thinks he can let the market fall, or growth slow, before harming his chances for reelection, we should prepare for potentially significant volatility ahead. If investors don't think they can stomach it, it would be better to reduce risk, or hedge positions, now. My biggest fear for our clients today is that we see a repeat of December, with too many selling out at the bottom and not getting back in again in time for the rally.

What happened?

Concerns over a breakdown in US-China trade talks have intensified, with the S&P 500 index sliding 1.7% and the Euro Stoxx 50 down 1.8% on Tuesday and the offshore Hang Seng index declining 1.2% on Wednesday. Hopes among investors that talks would get back on track were eroded after several top US officials expressed concern about the progress of negotiations. Treasury Secretary Steve Mnuchin said there had been a "big change in direction for the negotiations," while US Trade Representative Robert Lighthizer charged China with "reneging on prior commitments."

A return to heightened trade tensions would represent a threat to the rally and global growth. Our base case remains that the US and China will ultimately reach an agreement on trade. But near-term uncertainty is high.

What comes next?

The US has indicated that it will increase tariffs from 10% to 25% on USD 200bn of Chinese imports at 12:01 am on 10 May, and China has threatened to retaliate if the US follows through with this tariff increase. This could mark a return to a period of tit-for-tat tariffs, which contributed to a sharp fall in global equity markets in October last year. Uncertainty over trade also appears to have caused many companies to delay investment, and has led to a global slowdown in export growth and industrial production. A breakdown in US-China talks risks prolonging this soft patch in global growth.

In the event of a complete breakdown in talks and higher tariffs, we would expect to see US stocks trade 10%–15% below their highs and a fall of around 15%–20% in the Chinese market. Trade-exposed sectors could suffer the most, including technology, industrials, and energy. We would also expect an appreciation in risk-off currencies, including the Japanese yen, with the euro and emerging market currencies, especially the Chinese yuan, likely to be negatively impacted.

Investors also need to be mindful that, coming after a sustained period of low volatility so far in 2019, Tuesday's price action may also be in part driven by systematic investors reducing leverage. While leverage among volatility-targeting funds has not generally reached the levels of February or October 2018, this could contribute to outsized moves for markets over the short term.

Of course, there is still a chance that higher tariffs will be averted. China's top trade negotiator, Liu He, is still due to visit the US on 9–10 May for talks. Should a quick deal materialize, it would likely see markets eventually return to levels reached last week. But as it looks like there are a number of issues still to negotiate, a swift resolution isn't a given. It remains our base case that the US and China will ultimately reach a deal, but with the deadline for the imposition of new tariffs now very short, the path to that deal could well be bumpier than it once looked.

How should investors react? We recommend investors stay invested and not make major changes to their portfolios. Investors with excess cash should use the sell-off as an opportunity to put funds to work, including in companies exposed to secular growth.

That said, there is significant two-way uncertainty. If investors don't think they can tolerate the potential volatility ahead, making small changes to reduce risk or hedge would be appropriate. In our tactical asset allocation, we balance our overall pro-risk stance with countercyclical positions that can benefit in the event of higher volatility. We will be monitoring for greater clarity in the days ahead.