By Ira Iosebashvili and Dawn Lim 

Some prominent U.S. investors are buying Treasurys and planning to sell stocks, saying escalating trade tensions with China could threaten the 10-year bull market for equities.

Many have scrambled to reverse bets on an imminent deal between the U.S. and China and are now settled in for a dispute they expect to roil markets for months to come. Others are taking out insurance on further market declines by buying investments that rise in value when stocks fall, such as put options.

The flare-up brings back to the forefront concerns that had receded as markets coasted to new highs in recent months. They include concerns over fragile global growth, pricey U.S. stock valuations and China's capacity to continue stimulating its economy as its debt grows.

Investors pulled more than $22 billion from U.S.-stock-focused exchange- traded funds in the past two weeks as growing trade worries pressured markets, according to data from flows tracker EPFR Global.

Hopes for an easier path to a trade deal helped lift stocks in a series of advances last week after major indexes experienced their worst drop in four months on Monday. But a Bank of America Merrill Lynch poll of fund managers released last week found that just over a third have taken out protection against a sharp drop in equity markets over the next three months. That is the highest level in the survey's history.

"Clearly people have been positioned for smooth sailing, so that makes the markets' response to this tempest in a teapot kind of exaggerated," said Mark Spitznagel, chief investment officer of hedge fund Universa Investments, in an emailed message. However, "one of these days a spark like this will ignite another inferno."

Because China is the world's second-largest economy, its fortunes affect prices for a range of global markets, from stocks to soybeans.

Worries over a slowdown in China have already hit prices for industrial metals including copper and nickel, as well as the currencies of nations that count on Chinese demand for their exports. One casualty has been the South Korean won, which is down to its lowest level in more than two years against the dollar. South Korea sends around a quarter of its exports to China. At the same time, the trade tensions have hammered China's yuan to near its weakest level since late last year in offshore markets.

Jack McIntyre , who helps manage more than $55 billion in fixed-income investments for Brandywine Global, recently added to an already-overweight position in U.S. Treasurys when U.S. tensions with China worsened. He predicts that stocks could fall more than 10%, a drop worse than a market correction, if trade tensions rise.

At the same time, the potential of a steep stock slump is likely to keep President Trump from taking extreme measures against China, he said.

"Trump wants to be re-elected, so he can't run the risk of an equity meltdown," Mr. McIntyre said. "I think there has to be a deal. It's just a question of how bad does it get between now and then."

Mona Mahajan, an investment strategist and portfolio manager at Allianz Global Investors, has cut back her funds' exposure to Chinese and U.S. equities by selling stocks and buying put options.

"The risk of new tariffs has risen, a fundamental shift from the more amicable resolution regulators and policy makers had been expecting," she said.

Ms. Mahajan made an early call to start selling U.S. stocks over the past month before markets turned volatile. She continued cutting her exposure to U.S. equities more recently and reduced her exposure to Chinese equities, too. The decisions locked in some gains.

Others believe the recent turbulence may have uncovered bargains in markets that have become expensive over the past few months.

Jennifer Hartviksen, a portfolio manager at Invesco, reduced her position in high-yield bonds when prices rose earlier this year. She believes the trade dispute has created a buying opportunity for the $5 billion she manages across several portfolios.

"I wouldn't call it good news," she said. "I would call it an opportunity to find more attractive valuations....We're taking advantage of this volatility to hunt for deals."

For the longer term, some investors believe that the U.S. and China will remain at loggerheads on trade, technology and other issues, even if the current impasse is resolved.

Hugo Rogers, who oversees $5 billion as chief investment strategist at Deltec International Group, plans on lightening up on stock positions if a deal is announced.

"Many markets participants are talking about a China trade deal as a trigger to sell, and we are with them," he said. "A deal would make markets react positively and give a good exit point. But further conflicts will arise."

Carson Block, founder of short seller Muddy Waters LLC, said the U.S. administration has alternated between pushing for a more substantive realignment of the relationship with China and focusing on the S&P 500.

"However, the political calculus of Trump claiming the 'tough on China' mantle for 2020 makes me think it's probable there is a more substantive realignment than just China agreeing to buy more soybeans," Mr. Block said in emailed comments.

--Rachael Levy contributed to this article.

Write to Ira Iosebashvili at ira.iosebashvili@wsj.com and Dawn Lim at dawn.lim@wsj.com

(END) Dow Jones Newswires

May 19, 2019 06:14 ET (10:14 GMT)