US-China Phase 1, Now What?

Now that the long awaited Phase 1 deal has been signed between the US and China (significantly taking place in the White House) and details finally released (in a 94 page document) it’s worth asking whether much has actually changed.  After all, China still faces (high) tariffs on around two-thirds of its exports to the US while the deal does little to end Chinese state subsidies.  In return the US offers little aside from removing tariff increases.  Intellectual property transfer commitments agreed in the deal are mostly not new as China had already addressed most of these. 

Ironically the magnitude of Chinese purchases, ($77.7bn in manufactured goods, $32bn in agricultural goods, $52.4bn in energy and $37.9bn in services to Dec 2021) means that the Chinese State will have to be even more active in influencing its economy.  The reality is that to achieve this is going to be extremely difficult if not highly unlikely though this may ultimately not matter if China is seen to significantly increase its US purchases.

Looking ahead don’t expect China to be as agreeable on a Phase 2 deal; any such deal would touch on far more sensitive issues.  The likelihood of this being agreed and signed ahead of US elections or maybe at all, is low.  However, in the near term, the deal keeps the risk taps open and avoids any near-term escalation while President Trump walks away with another notch on his belt.  What it doesn’t do is stop any of the US non-tariff barriers, export controls etc, that will still hurt Chinese companies and push China to develop its own technology. Chinese growth will not get much of an uplift from the deal while markets have already largely priced it in.

The commitment from China on the Chinese yuan (CNY) looks vague (achieve market determined FX rate, strengthen underlying fundamentals, refrain from competitive devaluations, avoid large scale, persistent, one-sided intervention), but China will at least avoid any sharp devaluations (of the type experienced in mid-2015, Jan 16), not that they would want to do that again given the negative consequences on its markets/economy.  And as it is China has not been intervening significantly in FX markets for a long while so this should not be difficult either.

Calm After The Storm

The start of 2020 has not come without incident, to say the least.  The US killing of an Iranian general and Iranian missile strikes on US bases in Iraq prompted a flight to safety, with investors piling into gold, Japanese yen while pushing oil prices higher.   However, each time the impact has been short lived, with markets tending to move back towards a calmer tone.  What is underpinning this is the view that both sides do not want a war.  Indeed Iran stated that it has ‘concluded proportionate measures’ and does not ‘see escalation or war’ while President Trump tweeted that ‘All is well’ after the Iranian missile attacks. While the risk of escalation remains high, it does appear that neither side wants to become entangled in a much deeper and prolonged situation.

As such, while markets will remain nervous, and geopolitical risks will remain elevated, the market’s worst fears (all-out war) may not play out.  This leaves the backdrop of an improving economic environment and ongoing policy stimulus in place, which in turn will help provide overall support to risk assets including equities and emerging markets assets.  As my last post highlighted, two major risk factors threatening to detail market sentiment into year end were also lifted.  Unless there is a major escalation between the US and Iran this more sanguine tone, albeit with bouts of volatility, is likely to remain in place in the weeks ahead.  This also mean that attention will eventually turn back to data releases and economic fundamentals.

In this respect the news is not so bad.  Although the US ISM manufacturing index weakened further and deeper into contraction territory below 50 other data including the ISM non-manufacturing index which beat expectations coming in at , suggests that the US economy is still on a rosy path.  While the consensus expectations is for US payrolls to soften to a 160k increase in December compared to 266k previously, this will still leave a high average over recent months. The Fed for its part continues to provide monetary support and liquidity via its repo operations (Quantitative easing with another name) and is unlikely to reverse rate cuts.   Elsewhere globally the economic news is also improving, with data showing global economic stabilization into year end.

UK Elections and US-China trade: Removing Risk Factors

Following the euphoria over the decisive UK election result and the US/China “Phase 1” trade deal markets look primed to end the year on a positive footing.  Two of the major risk factors threatening to detail market sentiment into year end have at least been lifted.  However, some reality may begin to set in early into 2020, with investors recognizing that there are still major issues to be resolved both between the UK and Europe and between the US and China,

Although full details have yet to be revealed, Chinese officials will likely be relieved that the hike in tariffs scheduled for December 15 will now not go ahead. However, there are still questions on how China will ramp up its purchases of US agricultural goods anywhere near the $40-50bn mark that has been touted.

Also the dollar amount of the roll back in US tariffs is relatively small at around $9bn, which hardly moves the needle in terms of helping China’s growth prospects.  “The United States will be maintaining 25 percent tariffs on approximately $250 billion of Chinese imports, along with 7.5 percent tariffs on approximately $120 billion of Chinese imports.”  This still means that a substantial amount of tariffs on Chinese goods remains in place.

According to Trade Rep. Lighthizer, the deal will take effect 30 days after its signing, likely in early January. To sustain any improvement in sentiment around trade prospects there will need to be some concrete progress in removing previous tariffs as well as progress on structural issues (state subsides, technology transfers etc) in any Phase 2 or 3 dealss. The bottom line is that agreement in principle on “Phase 1” will need to be followed by further action soon, otherwise market sentiment will sour.

In the UK Prime Minister Johnson now has the votes to move forward with Brexit on January 31 but that will leave only 11 months to negotiate a deal with the EU. The transition period finishes at the end of 2020 unless of course there is an extension, something that Johnson has ruled out.  In the meantime the immediate focus will turn to the next Bank of England governor replacing Mark Carney.  This decision could take place this week.  Markets will also look to what fiscal steps the government will take in the weeks ahead.

GBP has rallied strongly over recent days and weeks, extending gains in the wake of the Conservative Party election win.  However, further gains will be harder to achieve given the challenges ahead.  UK equities have underperformed this year and are arguably relatively cheap from a valuation perspective, but further gains will also involve removing or at least reducing much of the uncertainty that has kept UK businesses from investing over recent months.  In the near term GBPUSD could struggle to break above 1.35 unless there is progress on the issues noted above.

Fed, ECB, UK elections In Focus

An event filled week lies ahead.  Several central bank decisions including the Federal Reserve FOMC (11th Dec), European Central Bank (ECB) (12 Dec) and Swiss National Bank (SNB)  (12 Dec) are on the calendar.  All of these major central banks are likely to leave policy unchanged and the meetings should prove to be uneventful.  Fed Chair Powell is likely to reiterate the Fed’s patient stance, with last Friday’s strong US November job report (payrolls rose 266k) effectively sealing the case for no change in policy at this meeting, even as a Phase 1 trade deal remains elusive.

Similarly recently firmer data in Europe have pushed back expectations of further ECB easing, though President Lagarde is likely to sound cautious highlighting her desire to maintain an accommodative monetary policy stance.  The picture is rather different for emerging market central banks this week, with policy easing likely from Turkey (12 Dec), Russia (13 Dec) and Brazil (12 Dec) while Philippines (12 Dec) is likely to keep policy unchanged.

UK general elections on Thursday will be closely watched, with GBP already having rallied above 1.30 vs USD as polls show a strong lead for Boris Johnson’s Conservative Party.  The main question is whether Johnson will have gained enough of a share of the vote to gain a majority, allowing him to push ahead with his Brexit plans, with Parliament voting to leave the European Union by Jan 31.

Polls may not be as accurate as assumed in the past given surprises over recent years including the Brexit vote itself, but the wide margin between the two parties highlights the relatively stronger position of the Conservatives going into the election.  Nonetheless, given that a lot is in the price already, the bigger (negative) reaction in GBP could come from a hung parliament or Labour win.

This week is also crunch time for a decision on the threatened December 15 tariffs on China.  As previously noted there is little sign of any deal on any Phase 1 trade deal.  It appears that issues such as the amount of purchases of US goods by China remain unresolved.  Recent comments by President Trump suggest that he is prepared to delay a deal even as far as past the US elections in November 2020.

Whether this is tactic to force China to agree on a deal or a real desire not to rush a deal is difficult to determine, but it seems as though Phase 1 will deal will not be signed this year given the limited time to do so.  December 15 tariffs could be delayed but this is also not guaranteed.  President Trump’s attention will also partly be on the potential for an impeachement vote in the House this week.

China Data Fuels A Good Start To The Week

Better than expected outcomes for China’s manufacturing purchasing managers indices (PMIs) in November, with the official PMI moving back above 50 into expansion territory and the Caixin PMI also surprising on the upside gave markets some fuel for a positive start to the week.   The data suggest that China’s manufacturing sector has found some respite, but the bounce may have been due to temporary factors, rather than a sustainable improvement in manufacturing conditions.  Indeed much going forward will depend on the outcome of US-China trade talks, initially on whether a phase 1 deal can be agreed upon any time soon.

News on the trade war front shows little sign of improvement at this stage, with reports that a US-China trade deal is now “stalled” due to the Hong Kong legislation passed by President Trump last week as well as reports that China wants a roll back in previous tariffs before any deal can be signed.  Nonetheless, while a ‘Phase 1’ trade deal by year end is increasingly moving out of the picture, markets appear to be sanguine about it, with risk assets shrugging off trade doubts for now.  Whether the good mood can continue will depend on a slate of data releases over the days ahead.

Following China’s PMIs, the US November ISM manufacturing survey will be released later today.  US manufacturing sentiment has come under growing pressure even as other sectors of the economy have shown resilience.  Another below 50 (contractionary) outcome is likely.  The other key release in the US this week is the November jobs report, for which the consensus is looking for a 188k increase in jobs, unemployment rate remaining at 3.6% and average earnings rising by 0.3% m/m. Such an outcome will be greeted positively by markets, likely extending the positive drum beat for equities and risk assets into next week.

There are also several central bank decisions worth highlighting this week including in Australia, Canada and India.  Both the Reserve Bank of Australia (RBA) and Bank of Canada (BoC) are likely to keep monetary policy unchanged, while the Reserve Bank of India (RBI) is likely to cut its policy rate by 25bps to combat a worsening growth outlook.  Indeed, Q3 GDP data released last week revealed the sixth sequential weakening in India’s growth rate, with growth coming in at a relatively weak 4.5% y/y. Despite a recent food price induced spike in inflation the RBI is likely to focus on the weaker growth trajectory in cutting rates.

A Lot Of Moving Parts

There are lot of moving parts driving market sentiment at present.  US economic news has helped to buoy markets this week after US Q3 GDP was revised higher in its second estimate, to 2.1% q/q while October durable goods orders came in stronger than expected.  However, the news that President Trump signed the Hong Kong Human Rights and Democracy Act after almost unanimous passage in Congress, has fueled some cautious.  Investors now await any retaliation from China and whether the Bill will get in the way of a Phase 1 trade deal.

On the trade front both the US and Chinese governments have said that there are closing in on a Phase 1 deal but as yet there has been no confirmation, with less and less time to agree a deal before the end of the year and more importantly before the next phase of tariffs kicks in on December 15.  One sticking point between the two sides appears to be what extent will the US administration roll back tariffs, with China likely wanting not only the tariffs scheduled to be implemented in mid-December to be rolled back but also the ones implemented in August.

Such a roll back in tariffs would be take place in exchange for increased Chinese purchases of US goods and perhaps stricter intellectual property regulations, but more structural issues such as state subsidies, technology transfers etc may be put back to later deals.  In the meantime markets do not appear overly concerned, with risk assets and equities in particular continuing to rally and volatility continuing to decline.  If there is no deal announced in the weeks ahead, markets could face a set back, but if agreement on a deal is to be merely pushed back into Q1 2020, the damage will be limited.

After its sharp fall over October the US dollar has gradually clawed back ground over recent weeks, helped by US asset market outperformance and consequently strong inflows into US assets.  As we move towards the end of the year it appears that the USD will maintain its top spot, much to the chagrin of the US administration and their preference for a weaker USD.

Cautious Sentiment Towards A Trade Deal

Markets continue to focus on the potential for a “Phase 1” trade deal between the US and China.   The stakes are high. President Trump who stated that tariffs on Chinese goods would be “raised very substantially” if no deal was struck between the two sides.  US officials also poured cold water over comments by Chinese officials at the end of last week that there had been an agreement to reduce tariffs in phases.  Markets will take a cautious tone given such comments but it is still likely that a deal of sorts will agreed upon in the next few weeks.

Both sides want a deal and while Trump has said that China wants one more than he does, the US administration may want to avoid fueling market turmoil as attention increasingly turns to next year’s US elections.  This suggests that a Phase 1 deal is more likely than not, but agreement on later Phases will be much harder given that there are various structural issues that remain unresolved such as technology transfers, intellectual property theft and state subsidies.

For now what is important is that markets believe that there is progress towards a deal and an eventual signing probably sometime in December.  Despite the harder rhetoric from the US side this still looks like the most likely outcome which in turn suggests that equities and other risk assets have room to rally.  In the meantime, the situation in Hong Kong where protests have intensified will weigh not just on Hong Kong’s markets but markets across the region adding another reason for market caution in the short term.

On the data and events front attention will be on US October CPI, retail sales and a crop of Fed speakers including Fed Chair Powell who is unlikely to change the view the Fed is on pause for the time being.  Elsewhere Chinese data has been less than impressive this week, with October aggregate financing and new yuan loans both coming in weaker than expected.   This is likely to be echoed by the retail sales and industrial production data this week too.

On the FX front, the US dollar has made up around of its October losses amid some deterioration in risk appetite.  Further moves will depend on the progress towards a trade deal, with the USD likely to be pressured should it become clearer that a deal is likely to be signed and vice-versa.  US retail sales data will also have some impact in the short term, but with the Fed on pause and US data holding up the USD the will be driven by driven by the gyrations in risk assets.

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