OCBC OneWealth App– Rendezvous at Osaka

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US-China trade tensions

Rendezvous at Osaka

26 June 2019

All eyes on the G-20 summit

Before 2018, G-20 summits were typically boring affairs. World leaders would gather to talk about the state of the world, agree on a message and go on their merry way, checking yet another box in a long list of international meetings they need to attend.

Yet, the G-20 meeting has taken on new importance in recent years – well, technically the side meetings, not the main event. At a dinner meeting after the G-20 summit in Buenos Aires in early December last year, President Donald Trump and President Xi Jinping agreed to a trade truce after months of escalating trade tensions and tit-for-tat tariffs. Negotiations restarted, and while the start was rocky, for the most part, political rhetoric was supportive, and the market thought both countries would reach the finish line and possibly ink a peace treaty.

Alas, that was not meant to be. Problems arose, and negotiations nearly broke down in early May. Tensions again escalated, and tariff shots were fired on both sides. Threats extended beyond tariffs to include business and export restrictions as well.

Expectations are that the upcoming G-20 summit will be, yet again, hallowed ground on which another truce is called, and negotiations restart.

Hopeful then, cautious now

Markets have risen in the lead up to this meeting. Indeed, US stocks had the best week in recent memory last week as market participants cheered a wave of positive developments.

The rally was first triggered by a dovish European Central Bank (ECB). ECB President Mario Draghi raised expectations that the central bank would dole out fresh monetary stimulus as early as its next policy meeting in July, in the face of tepid growth, weak inflation and declining inflation expectations.

Later, President Trump added fuel to the fire by tweeting that he had had a good conversation with President Xi Jinping and that a meeting with his Chinese counterpart in an extended session at the side-lines of the G20 summit later this week was mostly confirmed. This sparked optimism that US-China trade tensions had softened somewhat and that a trade truce might be called.

The Federal Reserve’s dovishness capped off a week of good news for market participants. Fed Chair Jerome Powell strongly signalled that policymakers could bring down interest rates as early as July, citing that the case for near-term monetary easing have strengthened given rising downside risks and softening inflation expectations. A compressed policy space marked by already low interest rates by historical standards suggests that an ounce of prevention via pre-emptive easing is worth more than cutting interest rates after the fact. An insurance cut – as it has been termed by market watchers – seem likely as early as next month, barring any upside surprise to economic performance.

Soothing words by the ECB, the Federal Reserve and President Trump were enough to push the Dow Jones Industrials and Nasdaq Composite just a whisker away from their 2018 records, while the S&P 500 index broke that level to set a fresh record high.

Yet, this episode seems familiar. While not a direct repeat of history, it certainly rhymes. Stocks rose sharply in the first few months on signals of a “patient” Fed and hopes of a trade deal. It took all of four months for the key US stock benchmarks to recover all losses from the trough of 2018. It took all of two weeks to recover the losses from its lowest point in May. And now, sitting close to 2019 peaks, we’re confronted with the same question as in April: Can the market head higher from here?

Chocolate cake in Osaka?

Much hinges on the outcome of the Trump-Xi meeting at the side-lines of the G-20 summit over 28-30 June. With President Trump and President Xi all but guaranteed to meet in Osaka, attention immediately shifts to the possible outcomes of the meeting.

From the outset, we can rule out the possibility of a comprehensive trade deal. In the absence of tangible progress in the interim, what was problematic at the beginning of May (when the talks fell apart) is likely to remain problematic at this meeting. Meaningful compromise on both sides is unlikely given the deterioration in political rhetoric.

Our base case

Like December last year, the best we can expect is a renewed commitment to re-engage in earnest negotiations with the hope that an eventual agreement can be inked some time down the line.
In this case, a second truce would likely be called. This would likely involve a commitment by the US to temporarily refrain from increasing tariffs on a further US$300 billion worth of Chinese imports. Current tariffs will likely remain in place.
Business limitations on Huawei could also be tempered as a gesture of goodwill to continue negotiations despite Congress’ objections. China could also retract its threats to restrict exports of processed heavy rare earths that the US relies on for high-tech industries.
Yet, given President Trump’s stated desire to have the Federal Reserve cut interest rates, it is unlikely that he would back away entirely from his tariff threats. In service to this indirect monetary policy goal, the Trump administration might find it favourable to prolong trade uncertainty by levying taxes on a fraction of the remainder of Chinese imports at possibly a rate lower than the initial 25% at a later date. This would introduce enough economic pressure for the Fed to proceed with insurance cuts and trade negotiators to work on a quick deal whilst reducing the impact on customers (although, ironically, this pain is entirely self-inflicted).
Given that attention and political effort in 2020 will likely be directed to President Trump’s re-election bid, this could be an impetus for negotiators to finalise a deal by year-end or at least before the campaign process begins in earnest. Indeed, a public photo-opportunity of the consummate deal-maker inking a deal with a strategic rival before the 2020 elections is too alluring to pass up.

This is only a conjecture, and we readily admit that predicting probable outcomes of a highly fluid political process is likely a fool’s errand.

While this remains our base case, President Trump has been known to surprise, and we should not be too eager to place all our eggs into one speculative basket.

Mixed signals

Admittedly, the signals from financial markets are confounding. The broad increase in risk assets has been accompanied by outperformance in safe havens like the Japanese Yen, Swiss Franc and gold. The seemingly persistent inversion in the 10Y-3M US treasury yield curve tells us that the bond market remains pessimistic about global growth.

The string that weaves both seemingly contradictory signals together seems to be monetary policy. The bond market is pricing in expectations that the Fed will ease policy in response to a pessimistic growth outlook while the equity market is pricing in optimism that lower borrowing costs could support the economy in the face of said pessimism as well as buttress risk sentiment. Safe havens have firmed, probably as a hedge against possible untoward outcomes at the G-20 meeting as well as rising geopolitical risks in the middle-east.

Put together, investors appear hopeful (equity market signal), but not too hopeful (bond market and safe haven signal).

How will the market react?

On trade, good news is good news for equity markets. Any indication of a tentative truce will be a positive catalyst that would likely send equity markets higher. As it stands, the market appears to be trading cautiously ahead of the meeting.

Yet, on monetary policy, bad news is good news for equity markets. Weakening economic data buttresses the case for near-term easing of monetary policy, which then boosts market sentiment. Trade tensions complicate this simple relationship, in large part because it is the main issue injecting uncertainty into the outlook, which is the basis for monetary policy.

If President Trump and President Xi somehow agree to ink a trade deal at the G-20 summit that eliminates tariffs on both sides and renews trading relations, US-China trade uncertainty diminishes, the outlook clears and the need to cut interest rates may dissipate. In this case, the Federal Reserve may choose to delay cuts in the near-term to monitor how data develops amid the brighter outlook. The word “patience” could re-emerge and take prominence again in the Fed’s policy vernacular.

An alternative outcome is also possible. If negotiations completely break down and the trade skirmish deteriorates into an all-out trade war, the outlook could materially worsen, hence motivating the Federal Reserve to urgently implement interest rate cuts to stave off any fall-out from heightened trade uncertainty. The Fed may continue to adopt a cautious stance until such time that the outlook stabilises.

Expectation is for the outcome to fall somewhere in between. Trade tensions will dissipate somewhat, but uncertainty remains in the interim as a deal is negotiated. Amid the slip in global growth, soft domestic inflation and weakening inflation expectations, the Federal Reserve may proceed with cutting interest rates for insurance in the near term. Taken together, this should still bode well for risk sentiment.

The safety net that is the central bank should keep sentiment supported even if the there was a breakdown in talks. As it stands, trade concerns have not had material impact on earnings on a broad scale. Sentiment will likely be challenged if bottom lines are impacted. This will be the focus of the third quarter earnings season. With markets trading at or close to 2019 peaks, disappointment could easily lead to a drastic climb down.

The next G-20 summit is scheduled for 21-22 November next year. Let’s hope the summit reverts to its intended dullness by then.

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