The S&P 500 reached another record high on Thursday and after the White House economic advisor Larry Kudlow said US and Chinese negotiators were “getting close” to a Phase 1 deal. But other media reports were less optimistic, including a FT report of US frustration with China for failing to offer “enough concessions to justify a reduction in US tariffs,” and a WSJ report that China is resisting a firm numerical commitment on agricultural purchases.
It can be difficult separating fact from fiction in the rhetoric around the US-China trade conflict. But, in our view, there have been material signs a deal is more likely, while monetary policy and economic fundamentals are also now more supportive:
- A phased rollback appears possible, now that China seems to have dropped its insistence on the removal of all tariffs as a condition of a deal. An agreement also looks more achievable with Phase 1 discussions focusing on tariffs and agricultural purchases, and thorny issues such as technology transfer, Chinese competition policy, and cyber intrusions less likely to be included. Meanwhile Democratic gains in this month’s elections in Kentucky, Virginia, and Mississippi may provide President Donald Trump with a greater incentive to reach a deal and “declare victory” on trade ahead of next year’s presidential election.
- Central bank accommodative monetary support has increased. The Federal Reserve and the European Central Bank have both eased policy since the summer. The Fed’s three interest rate cuts have helped steepen the yield curve and calm fears about an end to the economic cycle. Real rates are low. The real fed funds rate (fed funds minus core CPI) has fallen to -0.9%, compared with +0.2% at the July equity peak.
- There are signs of tentative economic stabilization. Germany’s manufacturing PMI rose from 41.7 in September to 42.1 in October, and the US manufacturing ISM climbed to 48.3 from 47.8. We expect that a moderation of trade tensions would further fuel the rebound in sentiment.
We now think upside and downside risks are slightly more balanced. While equity prices have risen and downside risks remain, upside potential has also increased. So we have closed our underweight position in emerging market (EM) equities, which could experience a sharp rally in the event of a rollback in tariffs. We are skeptical the US-China dispute will be completely resolved, but a Phase 1 deal would represent a step in the right direction and could lift EM sentiment and potentially reverse the recent decline in manufacturing PMI data. Given we now see a lower risk of tariff escalation there is more scope for EM earnings growth next year. We expect MSCI AC Asia ex Japan EPS growth at 10% for 2020.
After this position change we now have a neutral stance overall on equities. We continue to allocate our tactical risk budget more toward yield investments than growth. Our overweight exposure to US dollar-denominated emerging market sovereign bonds remains the same.
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