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Merrill Lynch quantitative strategist Savita Subramanian published a highly useful report on June 3 advising investors on how to position portfolios in an environment of rising global trade tensions. The strategist included the warning that “things are likely to get worse before they get better.”

The report was written with a U.S. perspective, so I’ve condensed the recommendations to those most applicable to Canadians. In short, buy stocks representing the highest-quality balance sheets, watch profit margins closely and – in the worst-case scenario of an extended trade war and stagflation – own gold, oil and cash.

Ms. Subramanian is clearly concerned about an extended trade-related confrontation between the United States and China. She cites Merrill Lynch’s structured product strategist Chris Flanagan, who in a May 10 research report argued the U.S. President has adopted the view of former adviser Steve Bannon that “economic war with China [is] existential … The economic stakes in the war couldn’t be higher and neither side is likely to back off from their positions very willingly.”

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Sharply higher equity market volatility as measured by the CBOE Volatility Index (VIX) will be the main consequence of a trade war, according to Merrill Lynch. Ms. Subramanian advises that high-quality stocks – those with the highest credit ratings – have historically outperformed during periods of a rising VIX index.

The accompanying chart breaks down U.S. stocks by credit rating and shows each category’s price correlation with the VIX index. The VIX index rises as market volatility increases so stocks that show a positive correlation are able to increase in value as markets become more volatile. Negative correlations occur for stocks that drop as the VIX climbs.

There is a clear and consistent pattern where companies with higher-quality balance sheets perform best during periods of volatility.

Ms. Subramanian says that declining profit margins are the key risk for equity markets in the event of an continuing trade dispute. Her analysis shows that almost half of the increase in corporate profit margins since 2004 has come from the globalization trend. Profitability has climbed as companies have learned to outsource to low-wage labour markets.

Trade restrictions both increase input costs for corporate production and also limit revenue opportunities from overseas customers. The end result is a significant drop in profit margins, so Canadian investors should avoid investments with significant operations or supply chains in countries, particularly China, where tariffs are being imposed.

There are myths about investing through geopolitical stress that Merrill Lynch warns against. Investors might reasonably be tempted to buy U.S. small-cap stocks because these companies derive most of their revenue domestically.

Market history, however, does not back this up – Ms. Subramanian points out that small-cap stocks underperform large-cap stocks when international tensions rise. Many smaller companies rely on multinationals as customers, and that demand dries up quickly.

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A sharp drop in corporate spending is another major investment risk arising from protectionist policies and the strategist notes this trend is already occurring for industrial and software firms. Executives are confronted with an uncertain environment and are unable to make decisions about capital allocation. Sectors such as technology, business consulting and employment agencies that rely on corporate clients would likely see a steady drop in sales as long as trade tensions continue.

Regarding technology stocks specifically, Ms. Subramanian still advocates an overweight portfolio allocation to the sector, but with important caveats. Semiconductor stocks, which have been bludgeoned in recent weeks, should be avoided until there’s more clarity on national sales restrictions for Huawei Technologies Co. Ltd. products. Network security providers and telecommunications equipment makers remain attractive, according to the strategist.

For Canadian investors, the primary takeaway from Merrill lynch’s extensive analysis is to emphasize the highest-quality companies – those with premier credit ratings – in their portfolios.

Investors should also follow profit margins closely for companies they hold. Declining profitability ratios could signal that trade restrictions are impairing the long-term growth outlook, resulting in lower valuation levels and stock prices.

Ms. Subramanian’s advice only holds for the duration of the trade dispute. Market volatility in recent weeks results to some degree from the arbitrary, unpredictable nature of U.S. policy announcements. Diplomatic tensions between the U.S. and China seem to be escalating for now, but a surprise turnaround in relations, even a quick trade deal, is one possible scenario in the weeks ahead. In that event, the sectors to avoid now become those with the biggest short-term upside.

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