China's top trade negotiator, Vice Premier Liu He, will arrive in Washington for talks on 10 October, amid hopes for an agreement between the US and China to ease trade tensions. Weekend news reports suggest that the topics up for discussion will be narrow, but Liu is viewed as a conciliatory voice in the discussions, and Beijing’s decision to resume purchases of US soybeans has also improved relations between the two countries.
The outcome of the current talks remains hard to predict, and we are considering a range of results. Our base case is for only modest progress, and given the recent deterioration in economic data, we retain a tactical underweight position in equities while awaiting the result, preferring carry strategies. That said, we will be watching events closely, and it is possible, if unlikely, that talks produce a grand bargain that includes the roll-back of tariffs and agreements on intellectual property, technology sharing, and competition policy. While we stand ready to react to such an outcome, one way of investor positioning for this potential outcome in advance, without adding exposure to downside risk, is through call options.
What outcomes are possible in the talks?
We set out our longer-term outlook for US-China trade relations applicable up to the November 2020 presidential election in our latest Global risk radar publication. Our base case, to which we assign a 50% probability, is for only modest progress in this round of talks. Modest progress averts further escalation while failing to resolve conflicts over intellectual property and subsidies. We assign a 35% probability to our downside scenario, in which further escalation leads toward a US recession, and a 15% probability to our upside scenario of a comprehensive trade deal.
The upcoming negotiations will help determine which of these scenarios the US and China are moving toward. We see five potential ones.
- Talks break down: This would heighten the chances of further rounds of trade retaliation, beyond the measures already scheduled. The US could announce further increases in the average tariff on Chinese goods, more restrictions on Chinese technology firms, or measures to limit portfolio flows from US investors into China. We consider this outcome unlikely, since it would increase the threat of a US recession ahead of the 2020 presidential election, and so reduce President Trump's chances of winning a second term. But it remains a possibility, and would hurt markets.
- Negotiations continue: The US and China fail to reach a deal but announce that talks will continue. With this outcome, we would expect the full set of tariff increases in the pipeline—including the introduction of a 15% rate on around USD 150bn of Chinese goods on 15 December—to come into effect. This outcome would be a setback for economic growth, although markets could take comfort if the US and China announce a date for a next round of talks.
- A truce is reinstated: China agrees to step up purchases of US agricultural goods and grants improved market access to certain US industries. In return, the US agrees to postpone implementing the latest round of tariff increases, pending further talks. Here the outcome would be moderately positive for markets in the short term, signaling less hostility. But the ongoing uncertainty related to the trade relationship would continue to hamper business investment, in our view, and create a headwind to global growth. Both a continuation of negotiations and the reintroduction of a truce would fit within the base case of our Risk Radar scenarios.
- An interim deal is reached: Scheduled tariff increases are suspended indefinitely, and the US could agree to roll back restrictions on Chinese technology firm Huawei. This outcome would be toward the positive end of expectations, and would set us on a path toward the upside scenario outlined in our Risk Radar. It would also likely push markets higher.
- A grand bargain is struck: The US agrees to roll back existing tariffs on China in return for agreement on an enforcement mechanism. While we assign only a 15% probability to this outcome, it remains possible. We note more conciliatory moves in the trade dispute have often been associated with equity or economic weakness, and we have seen signs that some of President Trump's core supporters in the 2016 election, most notably farmers, are losing patience with the trade war. This may encourage him to make bigger concessions. We would expect this outcome to spur a more marked upswing in stocks. Over the coming months, it would also increase the economic impact of the Federal Reserve's recent rate cuts, because reduced uncertainty would encourage more companies to take advantage of lower borrowing costs to fund investment. This would fit within the upside scenario of our Risk Radar.
What does this mean for investors?
The difficulty in predicting the final outcome of the trade dispute poses a challenge for investors. Not even the negotiators themselves can yet be confident of the final result. Against this uncertain backdrop, we have been cautious on stocks, and economic data has worsened. The ISM survey of US manufacturers has fallen to a post-2009 low and there are early signs of slowing job growth. Investors are increasingly on the alert for evidence that a global manufacturing contraction is spreading to the rest of the economy. Last week the US ISM non-manufacturing survey was the weakest it’s been in three years.
That said, we acknowledge that markets could move higher through the week, particularly if a trade deal is reached. Investors looking to position for this potential outcome in advance could consider adding call options, which are attractively priced at present, in our view. For example, as we go to print, the S&P 500 is trading at 2,938. A call option on the S&P 500, to 20 December 2019, struck at 3,100, (i.e. 5.5% out-of-the-money) is priced at 0.47%. To get a sense of how attractive calls are versus puts, consider the following: a 2,775 strike put on the S&P to the same date (i.e. 5.6% out-of-the-money) is priced at over 1.5%, more than three times as much as the call considered above.
Our positioning farther out will depend partly on the result of the talks, and on the market's reaction to them. The relative appeal of adding to or reducing exposure to US stocks will depend on the outcome of the negotiations, the economic backdrop, the willingness and ability of global policymakers to stem the slowdown, and where the market is trading in relation to the S&P 500 2,700–3,000 range that has prevailed for much of this year.
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