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How targeted bond ETFs can mitigate risks of trade conflict

Escalation in trade conflict between US and China provoked movements in credit spreads

By Morgane Delledonne, ETF Investment Strategist

The escalation in the trade conflict between the US and China since the beginning of May, which has included tariff hikes from both sides[1], has provoked movements in credit spreads for most exposed industries. 

Energy, IT and materials the biggest sector losers from tariffs

Since the start of May, the worst performing sectors in terms of Option-Adjusted Spreads (OAS) include energy, information technology and materials. President Trump’s proposed tariffs have hurt the US energy sector, as it relies on steel and aluminium for pipeline construction, which in turn affects the subsectors of materials. The information technology and communication sectors were also hit by higher tariffs and investors may continue to reprice credit risk higher following the decision by the Trump administration to ban the Chinese telecoms giant, Huawei, from acquiring US technology. A decision that could trigger retaliation from China. The decline in US Treasury yields amid the flight to safety has partially offset the spread widening of US corporate bonds in total return terms. Market participants are currently pricing in a 25 basis point (bps) cut of the fed funds rate with more than 80% chance in December (probability extracted from the fed funds futures market as of 30 May 2019). 

An increase in inflation could cause the Fed to react without economic support

The interest rate outlook will remain critical to any upside in credit, while new data on the sustainability of recent employment and economic strength will also be an important factor for the US corporate bond outlook. In the medium term, the new wave of tariffs could weaken the US growth outlook by increasing production costs, compressing corporate profit margins and reducing capital expenditure. In the absence of further corporate tax cuts or fiscal stimulus to absorb the extra production costs, US companies could increase product prices. A tail risk of this potential action is that the resulting upward pressure on inflation could then force the Federal Reserve to react by hiking rates without supportive economic conditions as the trade uncertainty is likely to affect employment and investments. 

Investors are shunning US bonds

Since early May, concerns over the trade environment have been holding back investment decisions, and investors have favoured government bonds and money markets over equity ETFs in the search for safety. Investors have already begun to reduce their US holdings and look for opportunities elsewhere; US corporate bond ETFs recorded net outflows in the month to 22 May 2019. 

BMOs corporate bond ETF range offers duration flexibility and regional diversification

Against this backdrop, global corporate bonds offer greater diversification benefits than US corporate bonds, as they are less directly exposed to the US-China trade dispute. The Bloomberg Barclays US Corporate index has an overweight in energy, IT and materials compared to the global aggregate corporate bond index – the very sectors most impacted by the trade tariffs. The BMO Bloomberg Barclays Corporate Bond (GBP hedged) UCITS ETF range provides investors with global credit exposure as subsets of the Bloomberg Barclays Global Aggregate Bond Index for various maturity buckets, offering duration flexibility and regional diversification. For more information on BMO Global Asset Management’s range of ETFs, visit our website.