May 6, 2019 – Risk markets were jolted awake on Monday morning, as U.S.–China trade risks resurfaced. On Sunday afternoon, President Trump posted on Twitter that he would be ratcheting up tariffs on China beginning Friday, May 10, if a deal is not reached by then. Specifically, the threat is to raise existing tariffs on $200 billion of Chinese exports to the U.S. from 10% to 25%, and to consider tariffs of up to 25% on a further $300 billion of Chinese exports, which would effectively encompass all Chinese exports to the U.S. The increase in tariffs on the $200 billion could probably occur in short order. The additional tariffs on $300 billion would most likely take some time to implement.

It has long been our base case that U.S.–China negotiations would not take a linear path, and instead a “two steps forward, one step back” type of progression was more likely. Over the past couple of months, we have heard policymakers on both sides giving assurances that talks were productive and moving forward (See previous blog post, Trade Deadline Punted. Now What?).That seemed to break down last week, and it is our understanding that a couple of major sticking points remain, including whether the U.S. will remove all existing tariffs immediately upon completion of a deal, and whether the Chinese will modify existing laws to comply with U.S. demands to relax forced technology transfer.

No part of U.S.–China trade negotiations are easy, including these and other final issues being discussed, but we see this as a step backward, not a total derailment of the progress made to date. It is encouraging to us that the trade negotiations seem to still be on track to take place in DC later this week, as originally scheduled. Assuming those talks do take place, it will be important to pay attention to whether China’s chief trade negotiator, Vice Premier Liu He, is in attendance. If he is part of the delegation at this week’s talks, it would be a positive sign for prospects of a deal. If he stays home, that would signal a higher likelihood that higher tariffs go into effect, and markets could take a leg lower. Also noteworthy are reports that Chinese policymakers are scrubbing their internet of Trump’s tariff tweets, suggesting a desire to control the public message to allow trade talks to progress. In our view, both President Trump and President Xi very much need a deal to keep their respective economies from faltering. This year’s stock market performance from the U.S. and Chinese markets (up 17% and 22%, respectively, to start the year) no doubt give both leaders the feeling that they have the upper hand, hence the late-stage, heavy-handed negotiating tactics from both sides. However, the underlying economies are still somewhat fragile:

  • We expect the U.S. economy to slow from 2018 levels but to grow at a healthy 2% rate in 2019. This outlook, however, hinges on capital investment and consumer spending, both of which could be severely impeded by higher tariffs and continued trade uncertainty.
  • China’s economy slowed materially throughout 2018 but has since shown signs of stabilization. Make no mistake, though, their recovery is still fragile despite several rounds of credit, monetary, and fiscal stimulus.

It remains our base case that the U.S. and China will come to an agreement that forestalls the further increase of tariffs, but with so much at stake (and such big egos in the room), the risk of a policy misstep is elevated. While an escalation of the tariff war is still a lower-probability event in our estimation (versus reaching a deal), it is one that could come with severe market and economic ramifications (See previous blog post, Are Investors too Complacent about Tariffs?), and it is a challenge to our core narrative and current positioning of an overweight to equities.

Trade concerns contributed heavily to the equity market’s hideous performance in the fourth quarter of last year. So are we in for a repeat correction? We do not think so. One important offsetting factor this time around, which was not present last time around (at least in the eyes of investors), is the Federal Reserve. Its Federal Open Market Committee (FOMC) has gone to great pains over the past four months to reassure the market that it is mindful of risks around trade, slowing global growth, and tightening financial conditions. The FOMC has also reduced expectations of further policy tightening, opening the door to the next move from the Fed being either a hike or a cut. A trade-related shock to the economy would probably be enough to get the Fed to cut rates next. (It has been our view that, outside of such a scenario or a similar negative shock to U.S. growth, the Fed’s next move is more likely to be a hike than a cut but that it will remain on hold in the near term.) Chinese policymakers would likely take aggressive, stimulative measures of their own to prop up their economy.

Core narrative

We expect the U.S. economy to expand in 2019 at a slower but stable rate of around 2%. We also are seeing signs that global growth may be in the process of bottoming. One very important risk to that outlook is a deterioration of the trade negotiations between the U.S. and China. President Trump’s latest tariff threats are a setback to negotiations, but we do not think they will derail the progress that has been made to date. As with any other piece of economic data, we are monitoring the “trend” rather than one data point. In our view, that “trend” is still toward a U.S.–China trade deal, but signs that a deal cannot be reached would be reason to reevaluate our overweight to equities.

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