Chinese renminbi (CNY) set to stay firm amid trade talks

Since the beginning of November, the onshore CNY and offshore CNH have strengthened by around 3.5% versus USD. Both are now trading at pivotal levels close to their 200 day moving averages. Their appreciation cannot be solely attributed to USD weakness, with the CNY CFETS trade weighted index appreciating by around 1.8% over same period. In other words China’s currency has outperformed many of its trading partners.

The relative strength of the CNY may be an effort by China to placate the US authorities ahead of trade talks. Indeed according to my estimate China has been selling USDCNY over the last few months, albeit not in large amounts. Interestingly China has not used the counter cyclical factor to push CNY lower as fixings have been stronger than market estimates only around 50% of the time over the last 3 months.

Much of the strengthening in the CNY move came after the US administration announced a pause in the trade war at the start of December, with a delay in the planned increase in tariffs from 10% to 25% on around half of Chinese exports to the US. The implication is that China does not want to antagonise the US administration with CNY weakness, despite the fact that recent Chinese trade numbers have been awful.

China had given itself some room to allow CNY appreciation by previously letting the currency fall by around 5.8% in trade weighted terms (from around 19 June 18 to end July 18) in the wake of the imposition of US tariffs. Its appreciation over recent weeks looks modest set against this background. As such CNY is likely to maintain a firm tone around the trade talks this week.

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All Eyes On US/China Trade Talks

A major focus for markets next weeks is the US/China trade talks in Washington.  After the US reportedly turned down an offer of preparatory talks this week talks will begin on Monday, with China’s Vice Commerce Minister, Vice Finance Minister and central bank, PBoC governor.

It is unclear who on the US side they will meet, but the idea is to prepare the ground for the heavy weight talks between US Trade Representative Lighthizer, US Treasury Secretary Mnuchin and China’s top economic official Liu He, from Jan 30 to 31.

Both sides need a win on trade and markets are pinning their hopes on some form of a deal. The reality is that they are still very far apart on a number of issues.  As highlighted by US commerce secretary Ross, a trade deal is “miles and miles” away.

The easier issues on the table are increased purchases of US goods by China, something that China has already said they will do, in order to help reduce the record Chinese trade surplus with the US.  The tougher issues are more structural, including forced technology transfers, state subsidies, discrimination against foreign companies, regulations on intellectual property etc.

Not only is the US determined to gain China’s agreement on the above issues, but is also looking to find ways to ensure compliance monitoring.  However, China does not believe that foreign companies are transferring technology to Chinese companies, while they have already offered measures to increase access to foreign investors.  Overall, this means there is little room for negotiation.

In any case with just over a month left before the March 1 deadline that President Trump has set before he imposes increased tariffs of 25% on around half of Chinese exports to the US, there is little time to thrash out a deal on the key structural issues that would likely satisfy the US administration.

The likelihood is that negotiations will not be completed, especially on structural issues, leaving markets very little to be excited about.  While both sides may leave the talks, claiming a degree of progress, this will not be sufficient to allay concerns.  Risk assets will look vulnerable against this background.

 

FX ‘Flash Crash’

Happy New Year! What a start its been so far.  Weak Chinese data kicked off the year yesterday, with a manufacturing sentiment gauge, the Caixin purchasing manager’s index (PMI), falling into contraction territory for the first time in 19 months, another sign of slowing growth in China’s economy.  This was echoed by other manufacturing PMIs, especially those of trade orientated countries in Asia.   Taking a look at global emerging market PMIs reveals a picture of broadly slowing growth.

Lack of progress on the trade front despite positive noises from both the US and China, and no sign of an ending of the US government shut down are similarly weighing on sentiment as are concerns about slowing US economic growth and of course Fed rate hikes.  The latest contributor to market angst is the lowering of Apple’s revenue outlook, with the company now expecting sales of around $84bn in the quarter ending Dec 29 from earlier estimates of $89bn to $93bn.

All of this and thin liquidity, with a Japanese holiday today and many market participants not back from holidays, contributed to very sharp moves in FX markets.  The biggest mover was the JPY, which surged, leading to an appreciation of around 7.7% versus the AUD at one point and strong gains against other currencies.  Some have attributed algorithmic platform pricing to the sharp FX moves today, but whatever the reason, it shows that markets are on edge.

Although US equity markets closed in positive territory yesterday (barely), the above factors suggest another day in the red for equity markets and risk assets today.  While the JPY has retraced some its sharp gains, it and other safe haven assets such as CHF and US Treasuries are likely to find firm demand in the current environment.   Although I would not suggest extrapolating early year trading too far into the future, the volatility in the first two trading days of the year will be concerning for investors after a painful 2018. More pain in the weeks ahead should not be ruled out.

 

Looking For The Silver Lining

As the end of the year approaches it would take a minor miracle of sorts to turn around a dismal performance for equity markets in December.   The S&P 500 has fallen by just over 12% year to date, but this performance is somewhat better than that of equity markets elsewhere around the world.  Meanwhile 10 year US Treasury yields have dropped by over 53 basis points from their high in early November.

A host of factors are weighing on markets including the US government shutdown, President Trump’s criticism of Fed policy, ongoing trade concerns, worries about a loss of US growth momentum, slowing Chinese growth, higher US rates, etc, etc.   The fact that the Fed maintained its stance towards hiking rates and balance sheet contraction at the last FOMC meeting has also weighed on markets.

A statement from US Treasury Secretary Mnuchin attempting to reassure markets about liquidity conditions among US banks didn’t help matters, especially as liquidity concerns were among the least of market concerns.  Drawing attention to liquidity may have only moved it higher up the list of focal points for markets.

The other major mover is oil prices, which have dropped even more sharply than other asset classes.  Brent crude has dropped by over 40% since its high on 3 October 2018.   This has helped to dampen inflationary expectations as well as helping large oil importers such as India.  However, while part of the reason for its drop has been still robust supply, worries about global growth are also weighing on the outlook for oil.

But its not all bad news and markets should look at the silver lining on the dark clouds overhanging markets.  The Fed has become somewhat more dovish in its rhetoric and its forecasts for further rate hikes.  US growth data is not weak and there is still sufficient stimulus in the pipeline to keep the economy on a reasonably firm growth path in the next few months.  Separately lower oil is a positive for global growth.

There are also constructive signs on the trade front, with both US and China appearing to show more willingness to arrive at a deal.  In particular, China appears to be backing down on its technology advancement that as core to its “Made In China 2025” policy. This is something that it at the core of US administration hawks’ demands and any sign of appeasement on this front could bode well for an eventual deal.

Not much good news

There are a plethora of issues weighing on asset markets though sentiment has improved slightly today.  Weak Chinese trade data over the weekend and a revision lower to Japanese GDP data yesterday added to growing global growth concerns, against the background of waning hopes of a resolution to the US-China trade war.

US administration comments that there was a hard deadline for trade talks have not helped sentiment either.  News today that Chinese Vice Premier Liu He spoke with US Treasury Secretary Mnuchin and US Trade Rep Lighthizer on a timetable and road map on trade talks provided some relief, however.

In the US, growth expectations are undergoing a shift and talk of a Fed pause is growing.  This would be considered as good news for EM if it wasn’t for the fact that a pause could be due to US growth concerns rather than any sense that the Fed was approaching its terminal rate.  US November CPI, retail sales, and industrial production data will give more clues, but I still think the Fed policy rates next week.

In the UK, Brexit worries have intensified following the decision by Prime Minister May to the delay the vote on a deal in parliament given she would most likely would have faced a defeat had it gone ahead.  May will now go on a tour of European capitals to try to improve the Brexit deal but prospects don’t look good, especially as European Council president Tusk has already ruled out any negotiation of the deal and in particular the Irish backstop.

GBP was pummeled as a result of the delay and will continue to struggle in the short term given the lack visibility.  A revised deal appears difficult while a hard Brexit and even a new referendum are all on the table.

US-China trade tensions show little sign of ending

Increasing tensions at the APEC summit between the US and China, which resulted in the failure to issue a joint communique (for the first time in APEC’s 29 year history) highlight the risks to any agreement at the G20 summit at the end of this month.   Consequently the chances of US tariffs on $250bn of Chinese goods rising from 10% to 25% in the new year remain  high as does the risks of tariffs on the remaining $267bn of goods exported to the US from China.  Contentious issues such as forced technology transfers remain a key stumbling block.

As the Trump-Xi meeting at the G20 leaders summit approaches, hopes of an agreement will grow, but as the APEC summit showed, there are still plenty of issues to negotiate.  US officials feel that China has not gone far enough to alleviate their concerns, especially on the topic of technology, with the hawks in the US administration likely to continue to maintain pressure on China to do more.  As it stands, prospects of a deal do not look good, suggesting that the trade war will intensify in the months ahead.

Despite all of this, the CNY CFETS trade weighted index has been remarkably stable and China’s focus on financial stability may continue as China avoids provoking the US and tries to limit the risks of intensifying capital outflows.  China may be wary of allowing a repeat of the drop in CNY that took place in June and July this year, for fear of fuelling an increase in domestic capital outflows.  However, if the USD strengthens further in broad terms, a break of USDCNY 7.00 is inevitable soon, even with a stable trade weighted currency.

Calm after the storm

After yesterday’s carnage, global equity markets have recovered some of their poise. Whether this is a pause before another wave of pressure or something more sustainable is debatable. It appears that US equities are finally succumbing to a plethora of bad news.  Higher US yields have driven the equity risk premium lower.  Also there’s probably a degree of profit taking ahead of the onset of the Q3 US earnings season.

At the same time valuations have become increasingly stretched.  For example, the S&P 500 price/earnings ratio is around 6% higher than its 5 year average while almost all emerging market price/earnings ratios are well below their 5 year averages.  While strong US growth prospects may justify some or even all of this differential, the gap with emerging markets has widened significantly.

While US President Trump blames an “out of control” US Federal Reserve, it would have been hard for the Fed to do anything else but raise policy rates at its last meeting.  If the Fed didn’t hike at the end of September, bond yields would like have moved even higher than the 3.26% reached on the 10 year US Treasury yield earlier this week as markets would have believed the Fed is falling behind the curve.   However, as US yields rise and the equity risk premium reacts, the opportunity cost of investing in equities rises too.

In the FX world the US dollar could succumb to more pressure if US equities fall further but as we saw yesterday, USD weakness may mainly be expressed versus other major currencies (EUR etc).  Emerging market currencies continue to face too many headwinds including higher US rates and tightening USD liquidity, as well as trade tariffs.  The fact that emerging market growth indicators are slowing, led by China, also does not bode well for EM assets.  Unfortunately that means that emerging market assets will not benefit for the time being from any rout in US assets despite their valuation differences.

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