To manage our portfolio risk, we have closed our overweight in emerging market equities relative to Swiss stocks, and add an underweight in the Australian dollar relative to the US dollar. This move came ahead of the US decision to increase tariffs from 10% to 25% on USD 200 bn of Chinese imports. China has vowed to retaliate, though at time of print details remain vague. While a U-turn is still possible, we may face a period of uncertainty and increased volatility ahead. The US-China rivalry remains deep-seated.Over the past few months, we have been adding counter cyclical positions and incrementally cutting exposure to equities as markets have climbed. We continue to execute on this strategy with uncertainty now increasing again.

What's going on with negotiations?

As expected, first-day talks between China's Liu He and US negotiators Robert Lighthizer and Steven Mnuchin failed to yield a breakthrough.Negotiations will resume Friday morning under the shadow of higher US tariffs, with the US Customs and Border Protection agency confirming a 25%duty would be imposed on US-bound cargoes leaving China after 12:01 EDT Friday. The two to three week delay before tariffs start to be collected, which reflects shipment time from China, offers a potential window of opportunity to reach a deal before the levies take effect. At time of print, the Chinese delegation said it “deeply regrets” the US tariff hike and that it would take“necessary countermeasures,” but so far has yet to detail planned retaliation

With new tariffs implemented, the direction of markets from here will hinge on 1) how China retaliates; 2) whether trade negotiations continue or break down completely; 3) whether the US begins groundwork on following through on the president's threat to impose duties on an additional USD 325 bn of Chinese goods; 4) whether the US goes on to raise tariffs on auto imports; 5) the monetary and fiscal policy response; and 6) the spillover for global economic growth.

Why are we taking action to mitigate risk?

The week's events have shown the lack of stability in US-China trade relations. A return to tit-for-tat tariffs between the US and China represents threat to the global economy and equity markets. Uncertainty over trade policy has been partly responsible for the recent slowdown in global trade and industrial output, and higher tariffs, if sustained, could also impact corporate profits globally.

With this in mind, we are making two adjustments to our portfolios to help manage risk. We close our overweight in emerging market equities versus Swiss equities, and add an underweight on the Australian dollar relative to the US dollar. Valuations across emerging markets remain attractive, but uncertainty about the impact of trade negotiations on global growth is likely to weigh on sentiment in the near term. Switzerland, in contrast, is not cheap on historical valuation metrics, but its defensive profile should support its relative performance in a choppy market, and recent quarterly earnings reports have been resilient.

Meanwhile, the Australian dollar is a cyclical currency that tends to suffer when risk aversion rises. Australia is heavily exposed to Chinese trade flows,and we think the RBA may be preparing for a rate cut. This could mean that while the currency can be expected to depreciate in a risk-off scenario, it also may not appreciate significantly in a risk-on scenario, making it an attractive portfolio underweight at this time.

After this week's decline in markets, isn't the risk already priced in?

US markets are down 2.5% from the 30 April all-time closing high, and Chinese stocks are down 4.7% over the same period.

However, this is a relatively modest decline in the context of strong performance this year, and there is the risk of additional downside if we see significant retaliation by China, a breakdown in talks, and the imposition of further tariffs. In this scenario, we would expect a fall of around 10%–15% in US equities and 15%–20% in the Chinese market. Trade-exposed sectors could suffer the most, including technology, industrial, and energy. We would also expect an appreciation in the Japanese yen, with the euro,Australian dollar, and emerging market currencies likely to be negatively impacted.

Why aren't we reducing risk further?

Our base case remains that the US and China will eventually reach some kind of accord. Both the US and China have strong incentives to reach a deal and we do not expect a complete breakdown in negotiations. We believe China may have overestimated the US desire for a swift deal, and is eager to repair the process. If so, any retaliation from China would likely be moderate.Equally, President Trump is eager to avoid a large fall in US markets, or damage to the economy ahead of the 2020 presidential election. Meanwhile,we should remember that the Federal Reserve and Chinese authorities can help mitigate the economic effects of continued trade uncertainty, and it is worth noting that even the 25% tariffs are unlikely to have a major impact on global growth.

In addition, after this week's decline in markets, some risk is now already priced in. From here, we believe that markets would be reassured by a measured response from China, indications over a new time frame for a conclusion to talks, and an absence of preparations for further tariff hikes from the US.

As such, while we make adjustments to our portfolio to manage downside risk, we are not taking an outright negative stance at this time. Our overall tactical positioning is now broadly neutral on risk, with pro-risk overweight positions in global and Japanese equities and in emerging market sovereign bonds, offset by underweight in Euro zone and UK stocks, and by our counter cyclical positions.

How should investors respond?

With potential for volatility and continued uncertainty ahead, investors need to stay invested for long-term portfolio growth, but also protect against near term risks. In our April note Plan, Protect, and Grow, we discussed how investors can both protect and position for growth, with protection strategies including put spreads, portfolio diversification, and selectivity in credit. Green bonds in particular can help investors mitigate risks in their credit portfolios, since they have a less cyclical profile. We also highlighted growth opportunities in high-quality dividend stocks, and in long-term sustainable and thematic opportunities.

In our global tactical asset allocation, we have prepared for downside risks by balancing our pro-risk positioning with counter cyclical positions, including exposure to the Japanese yen, a put option on the S&P 500, and an underweight in 2-year Italian government bonds. These positions have performed positively amid the recent sell-off.

The tariff hike is likely to keep volatility heightened for Chinese equities over the near term. We expect Beijing to roll out more fiscal easing and monetary measures to offset the potential adverse impact on China's economy. With this in mind, we favor real estate, materials, consumer staples and infrastructure sectors, as they are likely to benefit from further government easing. Meanwhile, we recommend avoiding domestic brokers and IT (hardware) sectors.

We will continue to make adjustments to our positioning as warranted by an evolving risk-return outlook, and keep you informed.