For this week’s Big Interview, I climbed the investment summit (figuratively speaking) to seek guidance from our stock-picking “sherpa” Jim Pearce.

Jim (pictured here) is the chief investment strategist of Personal Finance, our flagship publication. He began his career as a stockbroker in 1983 and over the years has managed client investment portfolios for major banks, brokerage firms and investment advisors.

Jim has a BA in Business Management from The College of William & Mary, and a CFP from the College for Financial Planning. I asked him about the state of the markets and the steps investors should take.

The U.S.-China trade war is weighing on the stock market. In particular, U.S. sanctions against Chinese telecom Huawei are pressuring the tech sector. What’s the likelihood that trade tensions get resolved before the 2020 elections?

I’m not sure that trade tensions will ever fully dissipate, but I believe some sort of deal with China will be reached before the 2020 elections. Both countries have too much to lose by allowing the current tariffs to remain in place beyond the end of this year.

President Trump promised his supporters strong economic growth, and a protracted trade war with China could swing the 2020 elections. For that reason, this is as a much a political issue as it is economic.

Until the trade slugfest ends, how should investors protect their portfolios from tariff-induced turmoil?

The simple solution is to buy a put option on the SPDR S&P 500 ETF (SPY) at a strike price that protects most of your portfolio. A put option increases in value when the underlying security goes down in value. That way, you don’t incur the transaction fees and tax implications of liquidating your entire portfolio. Instead, you are essentially purchasing an insurance policy on the overall stock market.

Alternatively, you could simply place stop orders beneath your equity positions to ensure that you are sold out of those positions if the market tanks. In that case, you would incur any transaction fees and income taxes due, but you would also be out of the market at a price that is acceptable to you. Paying some tax on a gain is always preferable to paying no tax on a loss!

Inflation seems muted, but are investors too complacent about price pressures? Do you see any signs that inflation might exceed expectations and flare up this year?

I don’t see much impetus for rising inflation until the trade dispute with China is resolved. But once a trade agreement with China is reached, then the Fed may reverse course and take a more hawkish stance towards future rate increases.

Even if the trade dispute with China never gets resolved, the federal deficit is projected to increase sharply over the next 10 years due to last year’s huge cut in corporate tax rates. That means the U.S. Treasury will have to offer higher interest rates to buyers of its securities to attract enough money to finance the expanding deficit.

What are the chances that the Federal Reserve this year surprises Wall Street by turning hawkish again on interest rates?

At the moment that does not appear likely, but an uptick in CPI (the Consumer Price Index) could cause Fed Chair Jerome Powell to revise his stance on rate hikes. Powell has made clear that a 2% annual growth rate in CPI is acceptable, but anything north of 3% would require immediate action.

The other half of the Fed’s “dual mandate” — maximum employment — will also influence how soon Powell feels compelled to adjust monetary policy. Again, the trade tariffs may soon result in workers being laid off which will reduce spending. However, if a trade deal is reached and workers have more money to spend, we may see an uptick in the CPI.

What types of assets or sectors seem particularly vulnerable to sell-offs right now?

Of course, the tech sector is especially vulnerable to the current trade standoff with China. Also, retailers that import from China are going to have to raise prices to offset the higher tariffs. In turn, that jeopardizes consumer stocks since the tariffs will leave less money to spend on other goods.

From a broader perspective, a slowdown in the economy as a result of trade tariffs is bad for almost the entire stock market. The only sector that may benefit from a recession is utilities, as investors flee growth stocks for high-dividend income payers.

In the context of current investment conditions, what asset allocations do you recommend?

My current asset allocation model is 50% stocks, 25% inflation hedges, 15% cash, and 10% bonds. However, that may change if the trade war with China goes on much longer. At some point, the risk of a recession becomes so high that a more defensive posture would be advisable.

In your mind, what’s the number one risk facing investors right now and what defensive measures can they take against it?

The number one risk is complacency. The past 10 years have been wonderful for stock market investors, but that can change in a hurry. The time to take action is now. If you still have the same asset allocation you had a year ago, you need to consider making some changes to it.

Only you can determine how much risk you are willing to take, and the best way to manage that level of risk. What you cannot do is bury your head in the sand and hope the problem magically goes away.

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