Is a trade deal likely?

There have been recent material signs that a breakdown in US-China trade talks is less likely than a “rollback” in tariffs.

by Mark Haefele, Chief Investment Officer, UBS Global Wealth Management

The winding road to Muscatine

In 1985 a young President Xi stayed in Muscatine, Iowa as part of a Chinese agricultural delegation. Fast-forward to today, and the rise in stocks over the past month suggests that many investors would like to see Presidents Trump and Xi meet, in a freezing field near Muscatine, Iowa posing for the world’s media with a giant USD 40bn check made out for tons of US soybeans.

Trade prospects have improved

We are skeptical about this particular image becoming a reality. Even the trade negotiators do not know at this point whether President Donald Trump will go ahead with his 15 December tariff escalation, and trade advisor Peter Navarro has poured cold water on the current state of the talks. Yet, in the past month, there have been material signs that a deal is more likely. In our view, the factors below make a complete breakdown in talks less likely and a “rollback” in tariffs more probable:

Greater likelihood of phased rollback

We consider it significant that the Chinese Ministry of Commerce is now touting its willingness to agree to the US removing the additional tariffs it has imposed “in phases.” As recently as July, that same Ministry said “If the two sides are to reach a deal, all imposed tariffs must be removed…China’s attitude on that is clear and consistent.”

More tangible proposals on Phase 1 agreement

Both sides seem amenable to accepting compartmentalized agreements that make negotiating a deal less complex. An example of a partial agreement would include purchases of agricultural goods by China and the rollback of Chinese tariffs on them. In exchange, the US may cancel the 5% tariff on USD 250bn of goods, which has been scheduled for October, and postpone the December tariff increase.

Mounting political pressure to declare victory

This month’s elections in Kentucky, Virginia, and Mississippi produced Democratic gains. Political pressure ahead of the 2020 elections is rising, and a workable agreement would enable President Trump to “declare victory” ahead of the vote.

Additionally, policy and fundamentals have become more supportive

Eased yield curve concerns due to Fed cuts

The Federal Reserve’s three interest rate cuts since July have helped steepen the yield curve. While we do not believe the yield curve is a great predictor of recessions, a return to a positively sloped curve has boosted financial sector performance, helped calm fears about an end to the economic cycle, and reduced the risk of a self-fulfilling downturn in investor and business confidence.

More accommodative monetary support

While the future path of monetary policy is now less clear, on the whole central banks have become even more supportive since the summer. The real fed funds rate fell since its July peak, and European bank lending conditions eased in 3Q. The Fed has also stated it could allow the economy to run hotter for longer.

Tentative economic and earnings stabilization

There have been signs of stabilization on manufacturing sentiment. We expect that a moderation of trade tensions would further fuel the rebound in sentiment. On the earnings front, consensus earnings per share expectations have now moderated to realistic levels with 3Q reporting season coming to a close.

Asset allocation

We have long maintained that, despite weakening economic data, central bank support would prevent a recession. Yet, after strong equity market performance this year, a re-escalation of trade tensions in August, and slowing growth, we felt that the best way to take risk was to emphasize earning yield rather than counting on further equity appreciation.

Now we see upside/downside risk is in a slightly better balance: 1) the US-China trade negotiations have made some progress; 2) central bank accommodation has increased; 3) corporate earnings expectations have fallen; and 4) there are tentative signs of economic stabilization. Despite higher prices and the downside risks in evidence, upside has also increased, in our view. We have closed our underweight position in emerging market equities, and have now adopted a neutral stance overall on equities.

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