Accident or not
Whether by design or accident, the trade negotiations between the U.S. and China took a turn for the worse a few weeks ago. Were it not for the subsequent tweets, comments and actions by both countries, one could have dismissed the early-May breakdown in talks as a hiccup or simply negotiation tactics. But as it stands, it seems increasingly likely the U.S.-China dispute is not going to be resolved any time soon. Unlike last year, when China went out of its way to re-engage the U.S. after the Trump administration threatened and eventually implemented higher tariffs, Chinese officials responded much more combative this time around.
Why the surprise
The deeper issues, such as intellectual property protection, technology transfer and access, compliance monitoring of any agreement, the removal of tariffs and the definition of an “equal playing field,” were never going to be resolved within a few months. However, there was the hope that some agreement on trade might soon be forthcoming with a commitment to continue dialogue on the outstanding issues. Comments from both sides up to the end of April not only suggested that the latter was possible, but also that it was the most likely outcome. These assumptions were shattered by a single tweet as the U.S. walked away from the negotiation table – and wrong-footed a complacent market.
Chinese equities sold off aggressively, dragging down emerging market equities in general. The U.S. market, on the other hand, remained surprisingly resilient, reflecting:
• Optimism that some sort of deal will be reached in the near future. Anecdotally, it is interesting to note that U.S. investors are more optimistic on a near-term outcome than investors in Asia. A recent J.P. Morgan global survey indicated that only a quarter of investors surveyed believe Phase III tariffs (i.e., tariffs on the remaining US$300 billion) will be implemented. Half of respondents still think a deal is possible, with 27% seeing a deal being struck in late June.
• The hope that the impact on the U.S. economy would be minimal and inflationary pressures resulting from the higher tariffs would be manageable in the current low inflation environment.
• The belief that the U.S. Federal Reserve put is firmly in place and any major disruption to the economy or markets will be met by interest rate cuts and possibly even renewed quantitative easing. The market is already pricing in at least 50 basis points (bps) of cuts in interest rates in the U.S. over the next 13 months, and the U.S. 10-year bond yield has plunged 30 bps in recent weeks to 2.30%, from a high of 3.26% in October 2018.* (*Source: Bloomberg L.P.)
Key developments since the breakdown in talks
All indicators are pointing to increased rather than decreased tensions:
• The threat of a 25% tariff on an additional US$300 billion of Chinese imports.
• Huawei restrictions.
• Possibility of restriction on Chinese surveillance companies.
• Renminbi weakness.
• Hawkish and non-conciliatory comments from both sides.
• Bipartisan support in the U.S. for “being tough” on China. There are huge differences as to what that implies but, ahead of next year’s U.S. election, no presidential candidate wants to be accused of “being soft” on China.
The way forward
Between tweets by U.S. President Donald Trump and the lack of clear insights into the views of China’s Politburo Standing Committee, predicting the eventual outcome is a mug’s game, but given the deep-rooted differences between and frustration on both sides, especially from the hawkish camps within both administrations, the path forward looks increasingly challenged. Thus, following the developments on the dispute remains essential for fund positioning, especially given the profoundly different market impact of a near-term resolution versus a drawn-out and escalating dispute.
Outlook and pointers
The tech fallout worries us even more than the trade fallout:
• The decision to proceed with additional tariffs (negative) and a potential meeting between Trump and China President Xi Jinping (positive) during the G20 gathering later in June.
• Increase in the “Technology Cold War.” This is a much more complex issue due to integrated supply chains but also a much more sensitive issue than trade for both countries. This is the true battle ground for the future and both countries know it.
• More regulations and motions passed in the U.S. to limit or curtail Chinese businesses in general.
• Chinese retaliation.
• Chinese yuan renminbi. The currency remains a great neutralizer of tariffs, but any meaningful weakness in the renminbi will send emerging market currencies into a tailspin. Just last night, the U.S. Commerce Department reported it would expand its capabilities to punish countries who are deemed to be “currency manipulators.”
• Any softening in the tone from politicians or policy-makers from either country.
• The economic impact. This is the one aspect that investors are not willing to fully price in yet as it will have dire consequences for risk assets. For the International Monetary Fund, many economists and policy-makers, the negative fallout from an unresolved U.S.-China trade dispute remains one of the bigger, if not the biggest, risks for continued global economic growth.
Even before the latest fallout, in most of the Signature equity and balanced funds we had been reducing our exposure to technology and some economic-sensitive sectors. Cash in the funds has been creeping higher and was increased even further following the fallout.
This is not the time to hold on to wishful thinking but neither to be dragged into the doomsday hole. This is a time to be informed, to be nimble and not to be blinded by the unexpected.
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Published May 29, 2019.