Should investors be optimistic on U.S.-China trade negotiations?
Since early October, the U.S. and China have returned to the negotiating table in an attempt to de-escalate their trade dispute. Recent news flow suggests that the “Phase One” negotiation is making steady progress and a formal agreement could be signed in coming weeks.
According to news reports, China is willing to step up its purchase of U.S. farm products, something that Beijing has been using in recent months to entice Washington to negotiate. Beijing could also improve provisions on intellectual property rights protection. In exchange, the U.S. would cancel the planned December 15 tariff increase, which would impact over USD 150billion of Chinese exports to the U.S. Some of the previous tariffs imposed by the U.S. could also be rolled back. This would depend on whether U.S. President Donald Trump is willing to make such concessions. There are also suggestions that some form of currency pact could be part of the agreement, but it is hard to see how this would be implemented in practice. As with previous rounds of negotiation, investors should be mindful that nothing is agreed until everything is agreed.
There are good reasons for both sides wanting to defuse the trade tension that has squeezed the global economy for the past 18 months. Corporate investment in both countries, and globally, have been damaged by the lingering uncertainties from trade tension. President Trump needs the economy to remain in good shape as we approach the 2020 elections. In China, both structural and cyclical factors are pushing economic growth lower. Consumption is a key pillar of growth but there are signs that this is also softening. Hence, a truce in trade war would provide a needed boost to confidence to both sides.
While there are reasons to be cautiously optimistic on the current phase of negotiations translating into an agreement, the discussion is going to be increasingly difficult going forward. In particular, technology development, capital flow and China’s long-term economic strategy are areas that the two sides would find it difficult to find a common ground. There is a bipartisan agreement that China is a competitive threat in a number of areas to the U.S. economy. More restrictive policies are warranted for national security reasons. It would be difficult to push Beijing to compromise in these areas. Hence, what comes after this “Phase One” agreement could make investors cautious again.
Whether a breakthrough can help to improve economic growth going into 2020 depends significantly on businesses’ reaction. We have seen a similar truce in November 2018 between the two sides, but no visible improvement in capital expenditure (Exhibit 1, the next page). The escalation of tariffs in May 2019 damaged business confidence again. As the old saying goes “Once bitten, twice shy.” CEOs may choose to wait and see before they step up investment again.
EXHIBIT 1: GLOBAL CAPITAL EXPENDITURES
Risk assets, especially equities, are enjoying a fourth quarter rebound. The negotiation is helping to improve investor sentiment. At the same time, this stronger risk appetite is prompting investors to interpret data and events in a more positive light. For example, global manufacturing Purchasing Managers’ Indices have started to stabilize following 6 months of steady decline. This was sufficient to convince investors that the worst is probably over in terms of a global slowdown. The U.S. Federal Reserve (Fed) indicated in its October Federal Open Market Committee meeting that it is done with rate cuts for now. This was seen as the Fed’s endorsement that the economy is not under recession threat.
Asian equities, especially markets (Singapore, South Korea and Taiwan) and sectors (electronics, industrial) exposed to trade are likely to benefit from this development. We would also expect the Chinese yuan, which has already risen by 1.6% in October, to gain against the U.S. dollar. This would translate into more resilience for Asian and emerging market currencies.
This sentiment could persist until the end of the year, especially if the truce does materialize. However, it is worth remembering that we are deep in the late economic cycle. Even as the risk of a recession in the U.S. in 2020 is still relatively low in our view, growth could be choppy and uneven. This would call for a greater emphasis on building resilience in our portfolios. Investors could take this opportunity of consolidation in U.S. Treasuries to rebuild their position in long duration fixed income.