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Why trade war complacency is foolish

Macro 5 minutes to read

Summary:  Forex markets have settled into apparent equanimity over the Sino-US trade war, while equities have regained some composure following Monday’s rout. But this complacency looks misplaced as the diplomatic standoff could run and run…

The mercurial President Trump, remaining optimistic about a “successful” deal with China, has given equity markets a shot in the arm, sparking a trade relief rally over the past 24 hours. But with the trade negotiations stalling in this diplomatic impasse, and likely to be in limbo until the G20 summit (June 28), how long will it be before tensions flare up again? Or is a 5% fall in the president’s beloved equity market, which we know he views as a live barometer of his success, enough to exercise the Trump put?

As ever, there are many unknowns and complexities, given the opacity of both sides negotiating strategies and we could miraculously have a deal by the G20. However, looking at the current standoff and each side’s complaints, it is hard to see how a compromise is reached by late June. It would therefore be complacent to rely on the hope of a deal being reached quickly. 

The situation could still get worse before it gets better, the US is currently preparing for a public hearing on another round of 25% tariffs and a June 1 deadline for China to raise the rate of additional tariffs to 25% on 2,493 US products is looming. Despite the calm of the past 24 hours, the market could continue to gyrate between risk-on/risk-off as sentiment is determined by trade headlines and tweets. 

This volatility may be creating pockets of value once we get through this period of turbulence, but the uncertainty shrouding the negotiating strategy means a bigger correction could be just around the corner if tensions continue to escalate. Just one tweet could erase all the positivity that we have seen overnight, and we have seen many times before that it is not unlike Trump to vacillate day to day. Even if the US/China negotiation is resolved, the tariff threat may be hitting the EU next, some Trump aides want 25% tariff on EU manufactured autos.

Whilst the comments from the US have been sounding more conciliatory, the rhetoric from China has hardened. As, Christ Dembik points out, it is interesting to note that in the previous rounds of trade disputes that occurred since Autumn 2018, People’s Daily articles mostly used the term “trade friction” instead of “trade war” until now… As of yesterday, all the articles and TV reports mention “trade war”. This terminology change means a lot and confirms that the negotiations have entered a more dangerous phase. 
It also appears that China is not buying Trump’s softened rhetoric. Hu Xijin, the outspoken editor in chief of the Global times, a state-controlled newspaper in the People's Republic of China, is widely thought of as a “mouthpiece” for Beijing outside of the party’s official statements. If that is true it seems the Chinese have thoroughly understood Trump’s strategy to support equity markets.

Before we sound the all clear on this recent bout of volatility, we can’t forget that the current diplomatic standoff plays into both sides' hands. As we noted last week,Trump needs to push hard on China and no deal is almost better than a bad deal at this stage. “The fight is more important than the resolution,” stated one of Trump's senior campaign officials.

With anti-China sentiment growing in the US and the trade negotiations under the global spotlight, the onus is on Trump not to squander this opportunity and to push hard against China. Trump also has more ammunition to stand firm, relative to last year, now that the Fed is no longer on autopilot with raising interest rates. Xi also can’t appear to be strongarmed by the US, particularly in this politically sensitive year (the 70th anniversary of the PRC). This means the conclusion of the trade deal could still be several months away, longer than markets anticipate thus allowing for a prolonged period of uncertainty, a risk that could be underpriced.

The stakes are high, neither side wants to lose face, but neither would be willing to suffer too much economic damage. Until stocks are lower or economic weakness is pervasively visible the incentive to compromise is perhaps some time away – another reason to avoid complacency. Or perhaps, being purely speculative, that is really the president’s true game, maybe he can suffer some market weakness then bully the Fed into cutting interest rates.

Whilst we game out the brinksmanship between the two sides data out of China today again confirmed the fragility of the Q1 recovery, something we have noted several times before.

Source: Bloomberg
The data for industrial production, fixed asset investment and retail sales was soft across the board, missing economists' forecasts. Retail sales rose at the slowest pace since 2003, again confirming that despite the Q1 GDP beat, China’s economic stabilisation remains delicate. The slide from last month’s bounce back is evident even before the US raised tariffs from 10% to 25% and likely means policy will remain supportive until a sustained stabilisation in the data is visible.

The silver lining for markets here is that more stimulus measures are likely coming in order to bolster economic growth until economic stabilisation is less fragile. This weaker data could also sway China’s hand in compromising more readily. If the Chinese economy has not stabilised even before this latest tariff hike, this could spur Xi into action on negotiating, or probably the more likely option is aggressive stimulus to offset pressure rendered by the trade war.

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