While a combination of many factors will drive markets over the medium term, investors may have trouble focusing on too many narratives at once. Right now, tensions between the US and its major trading partners continue to drive stock market volatility. We believe that a shared desire to avoid slower growth will push the US and China toward an eventual compromise. However, we also continue to assess the need for further downside protection, and believe market moves from here will hinge on six factors:
1. Whether trade negotiations continue or break down completely
The overt tension between China and the US increased last week as both sides tried to show that they are not under pressure to blink first.
2. How swiftly the US follows through on the president's threat to impose duties on an additional USD 300bn of Chinese imports
Preparations are being made to apply new tariffs to the remaining USD 300bn of Chinese imports not yet covered by levies, a process which will take about two months. If a deal is not reached at the late June G20 summit, fresh tariffs could potentially be quickly implemented thereafter.
The dispute runs far deeper than just tariffs on Chinese imports. President Donald Trump also signed an executive order declaring a national emergency relating to threats against communications technology, laying the groundwork for an outright US ban on Chinese telecom equipment company Huawei. Separately, the US Commerce Department added Huawei and 70 affiliates to its “entity list,” which may ultimately prevent them from buying US-made components. If enforced, a ban on Huawei’s US chip purchases would represent a significant escalation in US efforts to pressure China to enter a trade deal.
3. Whether China retaliates beyond the tariffs announced on 13 May
China increased tariffs on USD 60bn of US imports with rates of up to 25%, but so far there are no signs of further retaliatory measures. China has not yet indicated it will bring back higher tariffs on US auto imports, or stop purchases of US agricultural goods. This is a positive sign that suggests a willingness from China to reach a deal.
4. Whether the US goes on to raise tariffs on auto imports
President Trump delayed the decision on imposing tariffs on imported cars and parts “by up to six months,” to give the European Union and Japan time to agree to a deal that would “limit or restrict” imports into the US. The respite is good for markets, but the potential for eventual tariffs remains.
5. The monetary and fiscal policy response
Over the past two weeks the People's Bank of China has provided additional liquidity via its one-year medium-term lending facility, and cut the reserve requirement ratio (RRR) for some small- and medium-sized lenders. We expect a further 100–200bps in RRR cuts.
China’s policy response has not gone un-noticed in Washington. President Trump tweeted that if the Federal Reserve matched China’s stimulus “it would be game over, we win!” We would expect the Fed to resist political pressure, but this week’s FOMC minutes may shed light on whether trade uncertainties and softer economic data could push the central bank to cut rates.
6. The spillover for global economic growth
Industrial activity data in both the US and China weakened in April. This week’s US (and Eurozone) PMI business sentiment data for May may shed some light on how trade tensions are impacting sentiment. Last week, New York Fed President John Williams said he is focused on the latest survey data to gauge the impact of trade stress.
We expect volatility on the road to any agreement. Our base case is that a deal is eventually reached, that additional tariffs on the remaining USD 300bn of imports are not imposed, and there is a partial rollback of existing tariffs. However, we know President Trump likes to keep the world guessing and we assign a probability of just 50% to this base case scenario. It may require some economic and market pain to provide the US with sufficient motivation to de-escalate trade tensions.
So while we continue to recommend that investors remain invested for long-term growth, portfolio diversification is critical to managing near-term volatility. We also recommend a tactical overweight to long-duration Treasuries, and stress the importance of avoiding excessive credit risk. We will continue to monitor our positioning and make adjustments as warranted by the evolving risk-return outlook.
Both sides in the US-China trade dispute continue to talk tough. President Trump has delayed a decision on tariffs on autos, but is pressing ahead with preparations for levies on another USD 300bn of Chinese imports. Where markets move from here will depend on whether trade negotiations continue or break down completely; how swiftly the US follows through on President Donald Trump's threat to impose duties on an additional USD 300bn of Chinese goods; whether China retaliates any further; whether the US goes on to raise tariffs on auto imports; the monetary and fiscal policy response; and the spillover for global economic growth.