Staying steady in chaotic markets

Recent tariffs, rising protectionism, and an uncertain inflation outlook all reflect the heightened policy uncertainty, as illustrated by the Economic Policy Uncertainty (EPU) Index. This index measures the frequency of articles in newspapers that contain terms related to economy, policy, and uncertainty, reflecting the growing concerns among businesses and investors. Interestingly, there is a notable disconnect between this uncertainty and financial market volatility. See Fig 1.

While there might be various reasons contributing to this, i.e. some investors still being in the “it’s just a negotiating strategy” camp or the market’s perception of Trump’s growth-friendly policies offsetting volatility, the fact remains that Trump's "weaponisation of uncertainty" has been dialled up in his second term. There is no doubt that the pain from tariffs will trigger a chain reaction at both the macroeconomic and corporate levels. Market volatility is thus likely to be a constant feature.

Fig 1: The disconnect between uncertainty and financial market volatility

Source: Bloomberg, Economic Policy Uncertainty, and Eastspring Investments, Feb 2025

Economists at Goldman Sachs have estimated that across-the-board tariffs on Canada and Mexico would result in a 0.7% increase in core inflation and a 0.4% reduction in gross domestic product¹. The potential to drive up consumer prices is particularly concerning for investors, who fear a resurgence in inflation could prompt the US Federal Reserve (Fed) to halt its rate-cutting measures. As expected, the Fed paused its rate-cutting cycle in March, with Chair Powell stating that officials were 'waiting to see what policies are enacted' under the new president.

To ensure resilience in an unpredictable economic environment, investors should diversify their investments and modify their portfolios to be more defensive. For example, adding a low volatility (low vol) strategy can enhance the defensiveness of an overall investment portfolio. A defensive portfolio typically aims to limit losses during market selloffs.

To understand it better, let’s look at how a low volatility style, using the MSCI AC Asia Pacific ex Japan Minimum Volatility index as a proxy, reacted during President Trump’s first term in office, when the administration imposed tariffs in 2018. Between Mar 2018 and Dec 2018, both the US and China engaged in a tit-for-tat move by imposing tariffs on a wide range of goods.

The imposition of tariffs on a wide range of goods led to increased uncertainty and volatility in the markets. Equity markets directly linked to the trade war experienced notable declines, particularly in the latter half of the year. See Fig 2. In contrast, the Asian low vol index provided downside protection and delivered resilient performance throughout this period.

Fig 2: Impact of tariffs during the 2018 US-China trade war

Source: LSEG DataStream, MSCI, S&P, Eastspring Investments, Feb 2025

Given the evolving global economic landscape, we conducted a stress test to evaluate the potential impact of tariffs on a low vol portfolio. We utilised the Aladdin risk management systems' Global Trade Protectionism scenario to assess the impact of significant tariffs on global trade, inflation, interest rates, including retaliatory actions from affected countries. The test assumes that additional tariffs will result in higher domestic inflation, leading to increased interest rates and a stronger dollar, and considers potential selloffs in US companies which have supply chains heavily dependent on non-US inputs.

The results suggest that a low vol defensive style continues to protect the downside and deliver approximately 3% excess performance due to its defensive positions. See Fig 3. That said, we are fully aware that markets are forward-looking, and the macroeconomic and market impact from the Trump administration are likely to change from time to time.

Fig 3: Profit and loss impact from global trade protectionism

Source: BlackRock Aladdin, Eastspring Investments. Low vol style based on Min Vol Index, Feb 2025

Besides policy uncertainty, markets have also been rattled by the sudden emergence of China's DeepSeek Artificial Intelligence (AI) model with technology stocks impacted the most. When the news broke on Jan 27th, the Nasdaq 100 index tumbled by 3% while Nvidia experienced a sharp drawdown of 17%, one of the largest losses in market history. This event is a black swan for the AI industry, as DeepSeek's open-source model presents a direct challenge to proprietary AI offerings from US-dominated major players like Google (Gemini) and Microsoft (OpenAI).

Apart from its disruptive nature to the AI industry, this idiosyncratic event ironically highlights the need for diversification. Despite the overall decline in major market indices, under the surface, 351 stocks within the S&P 500, or approximately 70% of the constituents, ended the day higher. This is the highest number of stocks delivering positive performance when the overall market, as measured by the S&P 500, declined more than 1% since 2000. It was unprecedented over the past 25 years!

This type of price action further emphasises the importance of having a diversified portfolio. Making active bets across more than 350 positions allow investors to benefit from the fact that the selloff has not been indiscriminate, with markets distinguishing between winners and losers. Furthermore, a portfolio that diversified across sectors, countries, and importantly, investment styles, can ultimately deliver a resilient performance. Enhancing portfolio buffers with low volatility equity strategies can help cushion against downside risks and contribute to more stable returns in 2025.

Fig 4: Number of stocks that outperformed in down markets

Source: Bloomberg, S&P and Eastspring Investments, Jan 2025