US-China trade talks: back to the drawing board and what it means for markets

The G20 meeting between Xi and Trump has shown good intentions with the US and China coming back to the table and avoiding escalation, but we see no short-term resolution of the trade war. We maintain our current portfolio positioning.

On the positive side, the two sides have agreed to resume talks. The US has postponed its threat of additional tariffs on remaining Chinese goods worth roughly USD 325bn, and showed a willingness to ease restrictions on Huawei (although details are lacking for now). However, the existing tariffs will remain in place and there were no discussions about a process to remove them. How quickly talks can progress remains unclear, as the remaining issues proved the hardest to resolve in previous rounds.

Global trade flows are unlikely to recover materially as long as the existing measures remain in place and investment continues to suffer from uncertainty and lower business confidence. Any return to above-trend growth is questionable given the weakness in global trade, so the slowdown looks likely to persist over the coming months.

In this context, central banks – although limited in their influence on trade flows – will add to easing measures, looking to counter the slowdown. The Fed has effectively ended its tightening cycle, while the ECB eliminated the prospects of a rate hike before mid-2020 and has added accommodation via new TLTRO facilities. Both are likely to announce new measures in their upcoming meetings. In China, stimulus continues, while the PBoC has signaled that it is ready to boost growth. Several other central banks around the world have followed the example of the three majors and have shifted to easing, including Australia and New Zealand in the G10, as well as India and Russia in emerging markets.

In all, while the G-20 meeting did not result in a breakthrough, the two sides will come back to the table, averting the risk of a breakdown and renewed escalation. This puts us in the second scenario of our framework, where dialogue continues but a potential deal is postponed to late-2019 or even to 2020. While central banks will mitigate some of the uncertainty, a prolonged trade war makes a sharp recovery in the business cycle less likely.

Market impact and portfolio positioning

Investors are buying the trade war truce: Asian equity markets were supported by the news (CSI 300 +2.88%, Nikkei +2.13%, futures on S&P 500 +1.1% at the time of writing), while safe haven assets were generally trading lower (gold -1.4%, USDJPY up 0.4%). Yet, more importantly, the pricing of Fed cuts wasn’t affected by the G20 outcome: a 25 bps cut in July is still fully priced-in (four cuts expected at a 12-month horizon). US Treasury yields are marginally higher across the curve (2-3bps). USD/CNY has grinded lower, trading now below 6.85. 

The asset allocation decisions made over past few months – favouring carry strategies over equities while seeking diversification and hedges – reflected our expectations that this G20 meeting would not be a game changer. In this context, we keep our current portfolio positioning unchanged. More precisely, we think that the current relief rally should prove short-lived, as the weekend’s announcements are unlikely to trigger a sustained global trade recovery.

In this respect, the coming earnings season will be important. We still expect mid-single digit earnings growth in 2019, close to the long-term average, but we continue to watch for signs of trade uncertainty impact on companies’ CapEx and growth plans. Without additional support from declining bond yields (and the current market pricing for Fed cuts is already relatively aggressive in our view), equity prices have limited upside from now on and will primarily be driven by earnings dynamics (and the outlook on global trade as a result).

Supportive central banks are providing a counterbalance to trade uncertainty, against a background of slowing growth and low inflation, and we do not currently see catalysts for a meaningful increase in yields. Hence our preference for carry strategies such as emerging market debt in local currencies, corporate bonds and real estate.

While volatility is currently subdued, we should not be surprised if it rears its ugly head over the slow summer months. We thus maintain the portfolio hedges (JPY and gold, mainly). More specifically, after an impressive rise in June (+8%), gold may suffer from profit taking in the coming days but we think that the rationale for holding it in a multi-asset portfolio is reinforced today. Indeed, as the hopes of a quick recovery in global trade fade, Fed cuts are now warranted, such that USD depreciation should continue (see below) and investors’ search for alternatives to negatively yielding government bonds is here to stay. We have accordingly revised our 12-month target up to USD 1400/oz. In a geopolitical / financial stress scenario, we think that the USD 1500/oz mark may easily be reached.

Turning to the foreign exchange markets, we think it is useful to separate what we believe will be the near-term implications from the medium-term outlook.

As we recently discussed, the interplay between US yields and global growth expectations will be key to FX markets’ direction.

The small uptick in US yields experienced this morning (and potentially, some further small upward moves in the next few days) may lend support to the USD, especially against reserve, safe-haven currencies such as the yen and the Swiss franc. Nevertheless, we believe that this is likely to be short-lived because the Xi-Trump truce still leaves a meaningful amount of uncertainty that may lead to Fed easing, and also because US growth is set to slow on the back of fading fiscal impulses.

At the same time, although the odds of a strong rebound in global activity remain small, by avoiding new tariffs, the chances of an outright global contraction are reduced.

Fundamentally, and looking beyond the FX markets’ near-term reaction, we believe that the environment will be characterised by still low core yields, the Fed erring towards an easing cycle, and the fading probability of a global recession alongside some trade-related uncertainty.

In this respect, we stand by our call for (moderate) USD depreciation over the next few months. We expect small EURUSD gains (1.15 by year-end) and, once the dust settles, a resumption of USDJPY weakness given the likely Fed easing (JPY has exhibited a very high correlation with US yields), the maturity of the US business cycle and JPY undervaluation. That said, if this expectation of only a very small upward move in yields does not materialise, we stand ready to change our view and neutralise the short USDJPY position in our portfolios. GBP developments will largely be dictated by Brexit political headlines, which we see as sterling-negative over the next few months. In the meantime, we expect the recent strength of the Swiss franc to fade on the back of deeply negative rates and a dovish Swiss National Bank.

In emerging markets, we judge the G20 outcome as somewhat positive over the medium term because we believe investors will keep looking for yield. With a disaster scenario averted, we expect to turn gradually from neutral to constructive on emerging currencies. As long as our assumptions on US yields are right, we will opportunistically add to our EM FX overweight in our portfolios over the next few weeks. Finally, we expect CNY stability in the near term, and some appreciation against the US dollar by year-end.

As always, we continue to closely monitor future developments and will promptly communicate any change of views.