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US-China trade tensions

Trade truce at Osaka

1 July 2019

An 80-minute lunch meeting results in a stalemate on trade

As was the case last December, Chinese President Xi Jinping and US President Donald Trump called for yet another truce in the seemingly interminable US-China trade war saga.

Among the points agreed during the meeting were the following:

  • Trade negotiations will restart with no particular deadline set for further progress. Unlike in December, President Trump had said that he was “in no hurry” to finish a deal and that “the quality of the transaction is far more important” than the speed of negotiations, a marked climb down from December’s trade truce where a three-month deadline was set.
  • New tariffs on a further US$300 billion worth of Chinese imports will be delayed while existing tariffs will remain in place.
  • In a coup for China, Huawei will be granted some temporary exemptions from the export blacklist. US companies will be allowed to resume trade with Huawei on consumer products, but restrictions on trade of “strategic” products such as the 5G network system will remain.
  • In return, China has upped the amount of agricultural goods they will purchase from the US, although the exact amount is yet unknown.

This time central banks have agreed to play ball

The outcome of the meeting was broadly in-line with what the market had anticipated, if not moderately more positive.

Unlike in the last quarter of 2018 when a trade truce was accompanied by hawkish guidance from the Federal Reserve and the European Central bank, this time monetary authorities have adopted a decisively different tune, communicating a commitment to ease policy to support flagging economic momentum.

Dovish policy guidance by most developed market central banks have underpinned the recent rise in equity markets in the face of heightened trade policy uncertainty. Notably, the US stock market is mostly unchanged from April, having broadly offset the losses incurred in May despite the lack of improvement in US-China trade relations. Financial conditions remain loose as well despite the spike in tensions in early May.

Indeed, the prospect of near-term monetary policy support has been instrumental in convincing market participants that the economic slowdown is unlikely to devolve into a full-blown recession.

Dovish central banks + trade war détente = relief rally

In further good news for the markets, the supportive outcome from the G-20 summit removes the immediate tail risk of 25% tariffs on all Chinese imports and eases somewhat potential disruptions to businesses as it relates to Huawei.

Coupled with firming prospects of monetary easing in the remainder of the year, risk sentiment is likely to remain well-supported and may carry equity markets higher from current levels. Markets had traded cautiously ahead of the G-20 summit and, given the outcome, seem well-placed for a relief rally.

Equities will likely respond positively, and credit spreads will narrow. Safe havens like the US Treasuries, gold, Japanese Yen and Swiss Franc may take a breather on the back of a risk-on tone in the market. The Chinese yuan will likely strengthen while the US Dollar could remain sluggish as the Fed Funds futures market continue to price in better-than-even odds of interest rate cuts in 2019.

On a regional basis, Asia ex-Japan stocks will likely benefit the most from the recent calm in trade tensions and firming risk-on tone in the markets. The combination of a cautious Federal Reserve, weak US Dollar and a less antagonistic trade backdrop are key positives for the region’s risk assets.

Likewise, US stocks will benefit from a cooling of trade tensions as well as firming prospects of near-term interest rate cuts by the Federal Reserve. As it stands, company earnings have not been gravely impacted by trade concerns and year-on-year earnings growth remains firmly in positive territory.

We might also see a rotation out of more defensive sectors – like utilities, consumer staples and real estate investment trusts - that have benefitted from heightened risk aversion on the back of a rise in trade tensions towards more cyclical sectors – like information and technology and consumer discretionary - as investors grow more confident that economic momentum will be sustained with easier monetary conditions amid a less negative environment for trade. Of course, the durability of such sector rotation is contingent on incoming economic data confirming such bets.

Likewise, high yield bonds are well-placed to benefit from lower interest rates, low default rates, a reasonably sound growth environment and increased risk appetite in the wake of dovish central bank guidance and a temporary US-China trade truce.

The need for lasting trade peace

Yet, we should not be too dazzled by the potential flurry of risk-on markets that we neglect sound risk management.

For one, a trade truce is not a resolution. It is just a temporary ceasefire. Taking a step back, there has been no meaningful progress towards a deal. It’s only hitting a pause button on planned retaliations and setting up the scene for further negotiations. Indeed, we’ve seen before how this movie plays out.

While a truce offers the market some breathing room and may support risk sentiment in the near-term, we should not overlook the lessons of recent history. The path to a lasting deal is going to be a long, winding and rocky one. Until a final agreement is inked and the integrity of the global supply chain is not threatened, trade policy uncertainty will remain elevated. At the same time, there are still question marks over the Trump administration’s stance on auto imports, which is a particular risk to the European Union and Japan.

Recent history has shown that the White House has become increasingly volatile where trade policy is concerned. The short-lived tariff threat on Mexican imports earlier in June exemplifies this type of unpredictable policy-making.

As it stands, the crosscurrents emanating from trade policy uncertainty have crimped business investments, dampened manufacturing sentiment and weighed on global growth prospects.

Fortunately, service sectors, labour markets and consumer sentiment have not been significantly impacted by escalating trade tensions. To the contrary, these gauges have remained relatively solid. In addition, central banks seem ready to pull the trigger on pre-emptive monetary policy easing to fend off the late cycle slowdown and extend the period of economic expansion.

While this is well and good, it is certainly not a long-term panacea. Issues arising from politics require a political solution. This means that the only durable solution that spares the global economy from the lashes of volatile trade policy is a binding trade agreement. US Treasury Secretary Steven Mnuchin had said that a trade deal with China is about “90%” complete. The final 10% runway will invariably involve difficult compromises on issues of strategic importance. Some differences in opinion may well be intractable. As such, markets might still be rocked by the occasional tariff threat and potential breakdown in negotiations.

Against these risks, diversification and haven assets will still have a part to play in anchoring portfolio returns amid a still volatile and uncertain market.

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