What happened?

A further deterioration in US-China trade relations pushed the S&P 500 3% lower on Monday. Weakness spilled over into Asian trade, although the Hang Seng Index recovered sharp early losses to close 0.7% weaker on Tuesday, and after shedding 2.2% on Monday the Euro Stoxx 50 was trading 0.3% higher on Tuesday morning. At the time of writing, losses since Trump's threat last Thursday to impose further tariffs on Chinese imports were 4.6%, 5.8%, and 4.4% on the respective indexes. In addition, global bond yields have continued to fall, with the 10-year US Treasury yield down 26bps to 1.76% since 31 July and the German 10-year Bund yield dropping to a record low of –0.52%. Trump on Monday accused China of "currency manipulation" after the country's authorities allowed the yuan to reach a decade-plus low against the US dollar, with USDCNY breaching 7. There were also reports that China had instructed state-owned enterprises to suspend the purchase of US agricultural goods, such as soybeans.

These developments increase the risk that the trade truce struck between the US and China at the G20 summit on 29 June is ending and leading to a return to tit-for-tat retaliation. This would present a significant headwind for global growth, corporate profits, and markets. While recession risk has increased since the Federal Reserve cut interest rates last week, and markets are adjusting, a recession is not in our base case, and we believe that negotiators on both sides still have strong incentives to find a resolution that limits the economic damage.

What comes next?

The immediate concern for markets is to determine whether the conflict will evolve beyond today's "currency manipulator" comments. One of three scenarios looks likely to play out in the coming weeks:

What does this mean for investors?

Global stock markets have fallen the past few days and we believe they are broadly priced now for the 10% tariff being implemented. We consider a move to impose a 25% tariff on the full range of Chinese imports unlikely, since Trump may calculate that this would significantly raise the risk of a meaningful US slowdown, which could impede his re-election chances next year. Meanwhile, a retraction of the threat of 10% tariffs—or indications from the Federal Reserve that further easing is imminent—could help take stocks back to where they were last week.

Markets remain in flux—we don't know what the next Fed speaker might say, or the content of Trump's next tweet—and economic and earnings dynamism is relatively muted, but with global central banks already signaling their willingness to ease, we are not expecting a repeat of last year's fourth-quarter sell-off.

For now, we are inclined to see this pullback as a temporary pocket of volatility rather than the beginning of a bear market. Such "bull market corrections" are a common feature of market cycles; since 1900, the US equity market has seen a peak-to-trough decline of 5% about three times per year, with 10% losses occurring about once per year and 15% sell-offs occurring every other year.

We are not recommending any changes to our tactical asset allocation at this time, but we will be watching developments closely for opportunities. In the meantime, there are several steps that investors can take in response to the market uncertainty:

For more information on how to manage an uncertain short-term environment while continuing to invest for long-term goals, please see our Plan. Protect. Grow. report.

Should you have any comments or questions, please email ubs-ciowm@ubs.com.