The US and China agreed to continue talks during this weekend's meeting of G20 leaders in Japan, although they failed to make significant progress toward a deal to reduce tariffs and no joint statement was released. President Donald Trump said that talks with China were “back on track” and China’s foreign ministry quoted President Xi Jinping as saying that China was sincere about continuing negotiations, but that they should be “equal and show mutual respect”.
As of Monday morning, it appears that President Trump will not press ahead with fresh tariffs on USD 325bn of Chinese imports, which he had threatened to impose in the event of a breakdown in negotiations, but existing tariffs would not be lifted. The US president said that more tariffs would not be imposed “at least for the time being” and did not impose a deadline on the duration of the truce. He also said that China would buy a “tremendous” amount of food and agricultural products.
China had aimed to negotiate an end to curbs on various Chinese technology firms, notably Huawei, and the meeting offered some progress on this issue. President Trump said that Huawei would be allowed to buy equipment from US companies where there is no national security issue and that its removal from the US “entity list” would be looked at “very carefully”.
There was recognition from China that resolving the dispute is in both sides' interest. “One basic fact remains unchanged," President Xi said. "China and the US both benefit from cooperation and lose in confrontation”. But investors should remain braced for a bumpy ride toward a more conclusive deal. The Trump administration has also been pressing China to step up intellectual property protection, eliminate forced technology transfers, and secure greater access to its markets. China aims to negotiate a reversal of recent tariffs hikes by the US. Presidents Trump and Xi both have significant discretion over tariff policy, and sudden shifts in negotiating positions are possible, if unpredictable. Also, if criticism mounts that Trump has given too much ground in the terms of the truce, his position could abruptly shift and hurt risk assets.
The G20 meeting brought other positive news on global trade. The EU and Mercosur, the South American trading bloc, agreed to a trade deal after 20 years of negotiations. The deal, which will cut or remove tariffs, is the largest free trade agreement negotiated by the EU.
What comes next?
We expect talks to continue, with the most likely outcome a prolonged truce on trade. Both sides have incentive to avoid further rounds of retaliation. An escalating trade conflict could slow US growth ahead of next year's presidential election and potentially reduce President Trump's chances for re-election. China will also be keen to avoid further curbs by the US that could slow the development of its technology industry, which Chinese leaders see as critical to the nation's long-term success.
However, we also believe neither side is in a rush to make a deal. Both Presidents Trump and Xi appear to believe that they have strong cards to play.
Trump's approval ratings have been stable, suggesting that his tough stance in talks with China is not hurting him politically. Recent statements from the Federal Reserve give the US president reason to expect that the central bank will help offset any economic drag from uncertainty over trade. Nor have US markets been suffering. The S&P 500 hit a record high last week, having returned close to 19% this year.
China's economic data has shown more signs of strain, with industrial output growth slowing to the weakest pace since 2002. Despite this, Xi can use fiscal and monetary levers to support growth. We expect a further 100-200 basis points of cuts to China's reserve requirement ratio. The country can also seek to exert pressure on the US in a range of ways. It could threaten a ban on the export of rare earths or restrict certain US firms' access to China, although we don't expect these measures to be employed in our base case.
With neither side in a hurry, we believe a deal is unlikely over our tactical investment horizon.
How should investors react?
The outcome of the meeting is consistent with our investment stance. We hold an overweight position in equities versus US government bonds over our tactical investment horizon, but balanced with a position in long-maturity Treasury bonds.
We believe the Fed and other central banks will seek to offset the drag from trade uncertainty by keeping interest rates lower for longer. Barring unusually strong economic data in the run-up to its next meeting on 31 July, the Fed is likely to act pre-emptively to protect economic growth and underline its commitment to avoiding recession. The European Central Bank has also adopted a more dovish stance. Such central bank action will help keep growth at trend rates or only slightly below, we believe, providing a relatively supportive backdrop for stocks. But we favor a regionally selective approach. We are overweight US equities relative to international developed market stocks as we think the US market is better placed in this environment of heightened risk and growth uncertainty, and think that market gains for Eurozone equities in particular have outpaced economic fundamentals.
Overall though we do not foresee notable returns for any major asset class. Although we expect the Fed to cut rates, the market is exaggerating the size of these cuts, in our view. The yield on the 2-year US Treasury has fallen by around 60 basis points since early May, and the market is now priced for over 100 basis points of easing by the end of next year. We believe this is excessive given US economic data, which has remained relatively resilient. The unemployment rate, at 3.6%, is the lowest it's been in decades, economic growth remains close to trend, and financial conditions are accommodative. As a result, we are underweight US government bonds versus cash.
Among developed market currencies, we could see near-term outflows from safe haven currencies such as the Swiss franc and Japanese yen, as trade worries ease somewhat.