Taking Stock

As we get to the end of the week trade headlines are still continuing to capture most attention. However, it has been increasingly difficult for anyone to guess what comes next in the long running trade war between the US and China.  Most investors and analysts think the trade war will persist for a long while but President Trump tweeted that it would “fairly short” and that talks with China were on track to resume next months.

Markets are not convinced and becoming increasingly desensitised to the news flow over trade, which seems to shift from good to bad news on a regular basis.  For example, the decision to delay the imposition of tariffs on around $156bn of Chinese exports until December failed to fuel a bounce in US equities. The decision has also left Chinese officials unperturbed.  China has vowed to retaliate, stating that the US had “deviated from the correct track of consultation and settlement of differences”.

The situation in Hong Kong is adding another dimension to the trade war.   President Trump has said that believed China’s President Xi could “work that out in a humane fashion” while in contrast many in the US Congress are pushing for a stronger stance. The eventual reaction will depend on whether demonstrations persist and how China moves going forward.

Hong Kong’s economy and markets are under pressure too, unsurprisingly. The economy is now facing the prospect of a technical recession, with growth in the third quarter likely to be negative following a -0.3% q/q drop in GDP in the second quarter.   Industry bodies have revealed that tourism has dropped sharply, with double digit declines in hotel occupancy and sharp reductions in purchases by mainland tourists. The number of tour groups from mainland China have declined by close to 30% in June compared to the average this year while hotel occupancy rates are expected to drop 40% y/y in July.

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G20, Fed and Iran

Market attention this week will focus on Fed speakers, the G20 meeting and tensions between the US and Iran.  Here are my thoughts on all three:

Federal Reserve Chairman Powell and Vice Chair Williams are both scheduled to speak tomorrow.  Investors will be looking for any further clues on the path, timing and magnitude of Fed interest rates in the months ahead and whether they validate market expectations of easing at the July FOMC meeting.   Markets are already pricing in several cuts and a result the USD has weakened sharply over recent months, suggesting that the bar to an even more dovish stance is high.  Nonetheless, the Fed is at least likely to deliver a 25bp rate cut at the July meeting followed by at least one or two further hikes this year.

The main event this week (Fri-Sat) is the G20 meeting in Japan and in particular the potential meeting between Presidents Trump and Xi on the sidelines.  Expectations/optimism towards some form of progress on trade talks appears high.  Markets are set to remain upbeat heading into the G20, suggesting that risk assets will maintain their rally this week, which will bode well for equities. However, the reality is that the gap between both sides remain wide and there may be some positive noises emanating from the G20 on trade, concrete progress is likely to be limited.

Trump and Xi are likely to discuss a range of issues, with trade teams from both sides preparing the topics for discussion, after talks broke down last month.  It is likely that both Trump and Xi will agree to continue more formal talks, with both leaders sounding positive in the run up to the G20.  However, the threat of additional 25% US tariffs on the remaining $300bn of Chinese exports to the US, remains in place and it is unlikely that this will be taken off the table without some major concessions from China.  As I’ve previously stated it could take months before a concrete deal is agreed upon.  In the meantime global trade will continue to deteriorate.

Elsewhere geopolitical tensions remain in focus as President Trump threatens Iran with additional sanctions in an effort to force Iran to renegotiate the 2015 nuclear accord, as early as today. This follows Trump’s decision to call off planned air strikes in response to Iran’s shooting down of an unmanned drone.  Iranian oil exports have plunged as a result of sanctions and oil prices continue to react, rallying by around 8.7% in just under a week.  Markets will remain nervous over the risks of any further escalation, leaving oil prices susceptible to a further push higher.

 

What to look for from China this week

Market attention returns to China this week, with markets there opening after Chinese New Year Holidays.  US/China trade talks will dominate attention, with China’s Vice Premier Lie Hu meeting with US Treasury Secretary Mnuchin and Trade Representative Lighthizer in Beijing.  Tariffs are scheduled to be raised from 10% to 25% on $200bn worth of Chinese exports to the US on March 2.  If talks do not succeed it will act as another blow to the world economy.

The fact that US President Trump has said that he won’t meet China’s President Xi Jinping before March 1 suggests elevated risks of a no deal though both sides.  Moreover, US officials will be wary of being seen to give in to China given the broad based domestic support for a strong stance against China, suggesting that they will maintain a tough approach.  Even so, there is a huge incentive to arrive at a deal of sorts even if structural issues are left on the back burner.

At a time of slowing global growth and heightened trade tensions China’s January trade report will also be scrutinised this week.  Market expectations look for a sizeable 10.3% y/y drop in imports and a 3.3% y/y fall in exports.   The risks on imports in particular are skewed to the downside given the weakness in exports data from some of China’s trading partners in the region including South Korea, Taiwan, Singapore and Vietnam.  A weak outcome will result in a further intensification of concerns about China’s economy.

Another focal point is the direction of China’s currency (CNY).  As trade talks continue this week it is likely that China maintains a relatively stronger currency stance via stronger CNY fixings versus USD and stronger trade weighted (CFETS CNY nominal effective exchange rate).  As it is the CFETS index is currently around its highest level in 7 months.  Of course, if trade talks fail this could easily reverse as China retaliates to an increase in US tariffs.

 

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.

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