Macro monthly | Market commentary Incentives and constraints for Trump and Xi in trade negotiations

Are the incentives of Presidents Trump and Xi aligned to avoid a damaging trade war?

06 Aug 2018

Highlights

  • Tensions between the US and China are likely to rise in coming months
  • Expect market volatility to pick up as the Trump administration presses ahead with tariffs
  • Investors should not underestimate growth stabilization outside of the US, including the effects of China’s monetary and fiscal stimulus
  • Remain constructive on global equities, with a keen focus on whether trade disruptions are meaningfully affecting business investment and hiring decisions
  • Hedges for further trade escalation include US duration and short the Chinese yuan and Korean won versus the safe haven Japanese yen

Incentives and constraints for Trump and Xi

Back in March, we wrote that while a miscalculated step in trade negotiations was a risk to economy and markets, Presidents Trump and Xi are sufficiently aligned to avoid a damaging trade war. However, the stakes now have surely risen.

President Trump is incentivized to continue pushing China on trade over the coming months. Polls suggest a majority of US voters are skeptical of the benefits of global trade and are generally favorable towards confronting China with tariffs.

The outperformance of the US economy and equity markets, energized by fiscal stimulus, emboldens the President to engage further. He has also offered economic support for the agricultural sector, a loser from Chinese retaliation and key voting bloc ahead of the November midterms. On the other hand, the President has arguably prioritized the US economy and jobs above all else. To the extent his policies create genuine damage to markets or the economy, President Trump may feel the need to dial back pressure.

China’s President Xi also has incentives and constraints for further engagement. Having shored up his leadership earlier this year, he does not face the same political pressures as President Trump.

Xi may feel he can ride out the US political cycle, prizing Chinese advancement and modernization associated with its Made in China 2025 plan with the clear goal of emerging as a genuine global superpower. Moreover, China has recently taken a number of steps to stimulate the economy, including:

  • lowering reserve requirements,
  • increasing liquidity,
  • encouraging lending to small and medium enterprises,
  • cutting taxes; and
  • allowing the yuan to weaken.

Still, China’s growth engine depends on global trade and a trade war is already disrupting the deleveraging process that China’s leadership views as key to long-term stability.

Given these dynamics, it is of course very difficult to predict how US-China tensions will all play out. At this point we think it’s reasonable to assume that tensions will heighten in the near term as there are still no signs of formal negotiations and the Trump administration is politically incentivized to impose the 10-25%/USD 200bn tariff in September.

China’s next move will be key. There is reason to believe China will retaliate but not proportionately; China’s formal response to the initiation of the latest round of US tariffs was less confrontational and specific as it was to the initial USD 50bn announcement. A less than fully proportional retaliation would create some near-term de-escalation, allowing China to appeal to the WTO and setting the stage for a return of bilateral negotiations. But clearly there is a meaningful risk of ongoing tit-for-tat escalation that undermines economic growth and risk sentiment.

The bottom line for investors

Overweight global equities despite the expectation of some trade escalation and associated market volatility over coming months. Ex-US growth is showing initial signs of stabilization, which is removing upward pressure on the US dollar. Markets should not underestimate China’s recent pivot back towards stimulus and its implications for global growth and commodities.  The combination of a stable dollar, China’s stimulus, still solid global growth and earnings should provide a cushion amid non-negligible trade risks.

Valuations for emerging market assets have become much more attractive and are already discounting significant trade escalation. As such we have begun adding EM exposure in some strategies.

In fixed income, we maintain neutral exposure to US Treasuries in case trade escalation leads to a flight to quality or a dovish re-pricing of expected Fed tightening.

And in FX, we are short the Chinese Yuan and Korean Won and long the safe haven Yen to hedge against further trade disruption.