A serious setback in US-China trade talks? What could happen next and market implications

Key takeaways

• In an unexpected U-turn, President Trump threatened on Sunday 5 May 2019 to increase his 10% tariffs to 25% on USD 200 billion of imports from China, and hinted that new tariffs could be imposed on import items that have escaped the trade dispute thus far.
• The move has taken financial markets by surprise as the evidence had so far suggested good progress in the US-China trade discussions.
• In this note, we elaborate on the three scenarios we see going forward – namely 1) a deal reached in June (60% probability), 2) postponement of the deal to late 2019 or 2020 (25% probability), and 3) a complete breakdown of the negotiations (15% probability) – and discuss the respective market implications.

Trump’s tweet on China unsettles markets

In an unexpected U-turn, President Trump threatened on Sunday 5 May 2019 to increase his 10% tariffs to 25% on USD 200 billion of imports from China, and hinted that new tariffs could be imposed on import items that have escaped the trade dispute thus far. Trump explained that the reason for his new threats was slow progress in the bilateral negotiations.

As a reminder, Trump had imposed duties of 25 percent on an initial USD 50 billion of Chinese goods last year, and then 10 percent on an additional USD 200 billion of products in September 2018. These supplementary duties were set to rise to 25 percent on January, but the increase was pushed back as talks continued. However, the US president has now threatened that, starting this coming Friday, he will impose 25% tariffs on USD 250 bn worth of Chinese goods, with an additional threat to impose 25% tariffs on USD 325 bn of Chinese goods “shortly”.

As a result, Chinese equities have sold off by over 5%, European stocks are down around 2%, while US futures are losing close to 1.5% for the day (data as of 6 May 2019). The US dollar is broadly stronger (except against the yen), USDCNY has rallied towards 6.77, oil prices are weaker, and the US 10-year yield is now trading at 2.48% vs 2.52% as of close of last Friday.

What happens next and the likely market implications

We see three potential outcomes from here.

1. A deal in June, which remains our base case (60% probability), helping the trade recovery materialise and boosting global economic activity. We think that the US president is putting pressure on the Chinese in the late stages of the negotiations to show he is serious about getting a good deal for the US, and that he will not hesitate to walk away if needed. The fact that China has not yet formally cancelled Vice Premier Liu He’s trip to DC suggests that the door for a compromise remains open. If both sides strike a compromise ahead of the G20 meeting in June, then the prospects for a recovery remain sound.
   
   Market implications: Under this positive (and our central) scenario, we think most of the good news has already been priced by the markets and the recent weakness would revert relatively swiftly. Following that and alongside the maturity of the US business cycle, we expect equities to perform reasonably but certainly not maintain their momentum of Q1 19. The Federal Reserve Bank (Fed’s) dovish stance warrants US yields stabilising near 2.5%, with some risk of further decline later this year as US growth slows due to the waning of the US fiscal impulses. Emerging market assets should benefit from this environment and perform rather decently on the back of trade normalisation, some improvement in global data, and a Fed remaining on hold.
   
   EM local debt should benefit from attractive carry, while high-yielding EM currencies with good fundamentals and prospects of reform implementation should outperform. Our favourite pick remains the RUB, but we also believe that the passing of social security reforms in Brazil will ultimately boost the undervalued BRL; we would also look for upside in CNY and MXN. In general, we would continue to expect a gradual dollar depreciation, although EURUSD could still struggle over the next few months because of a very dovish European Central Bank. We think more substantial EURUSD strength will come later in the year and towards 2020.
    
2. The deal is postponed towards late 2019 or 2020 (25% probability). If a deal is not reached by June as initially expected, but both sides do continue working on a pre-(US) election deal, the uncertainty will carry on for months, until a compromise is finally reached before the 2020 elections. With uncertainty prevailing, the risk is that the trade-related weakness already witnessed in the manufacturing sector will spill over to the domestic side of global economies, which have been resilient so far. In this case, the recovery in trade and manufacturing would be delayed, putting domestic demand and markets under pressure for the near future.
   
   Market implications: Markets this year have priced in the positive scenario of a resolution (MSCI World equities up by 15% on a YTD basis), so steps in the opposite direction would lead to a reversal of these moves. However, it is possible that their reversal would be less pronounced because US yields are now at much lower levels than they were in H2 18.
   
   This strategy of “kicking the can down the road” will keep investors at bay and supress sentiment. In such a scenario, equities would suffer and give back some of their gains so far this year, with Chinese stocks likely underperforming. Commodities would be subjected to broad-based pressure under the threat of reduced aggregate demand, while gold prices would rise (as they did during the market collapse late last year, gaining 7% between mid-November and end-December). Core bond prices would rise and yields would retreat, with US 10-year yields falling below 2.4% – likely because global growth prospects would have diminished while the probability of a Fed rate cut later in the year would have risen. High beta fixed income would suffer from spread widening and outflows, while IG corporate bonds should be more immune thanks to their rates sensitivity. EM debt would likely decline, although by less than it did during H2 18 given the significantly lower level of US yields.
   
   In FX, the currencies most vulnerable to such a shift would be those of open economies as well as those for which monetary policy expectations had shifted towards the hawkish side (Norway). These include EUR, AUD, NOK, NZD, and CAD. JPY would likely be the main beneficiary in this environment, while CHF would probably gain somewhat against the EUR and other commodity-related currencies. Nonetheless, such gains should be limited, as the experience of December 2018 showed, and JPYCHF would likely rally (in Q4 18, during the market meltdown, the pair rose by 3.8%). In EM FX, ZAR and TRY would be most at risk of sell-offs; RUB would suffer as well, retracing some of this year’s gains (alongside some weakening in oil prices); and CNY would come under renewed downside pressure.
    
3. No deal and trade talks completely break down (15% probability). This outcome remains the most unlikely in our view, as this is a “lose-lose” situation – in neither side’s economic or political interest. Nonetheless, the recent escalation means its probability has increased marginally.
   
   If both sides fail to produce a compromise in the coming weeks, then the likelihood of the sharp rise in US tariffs and China’s retaliation via the weaker yuan will spike. A prolonged negative supply shock and weak trade would hurt global economies to a point where it might be difficult to avoid a recession. In that case, neither side would have an incentive to return to the negotiating table until political events – quite likely the US presidential election in 2020 – create an incentive.
   
   Market implications: In such an adverse scenario, the market implications we described in outcome number 2 (postponement) would still be valid in terms of direction, but the moves would be far more abrupt and pronounced. Global equities would likely reverse all of this year’s gains, implied volatility would increase sharply – with the VIX volatility index potentially testing the 30% level (currently at 17%), and core bond yields would fall across the board: US 10-year yields could potentially drop to the 2.20-2.00% range. The gold price would rally by around 10%, consistent with such a US yield range. Credit spreads would widen meaningfully in this context.
   
   EM assets would be under severe pressure. We would not rule out USDCNY moving closer to the 6.90-7.00 range or EURUSD falling towards 1.10 (or below). Other high-beta currencies like ZAR, TRY, BRL, and IDR would come under significant pressure. However, the decline in US yields (the US economy would slow further and markets would price in Fed easing as nearly certain) and the fact that the financial market meltdown would increase pressure on the US administration to provide a solution would likely alleviate these pressures on risk appetite. Still, it would take time and would doubtless leave a very noticeable negative mark on risk assets, potentially increasing the probability of a swift global recession.

In conclusion, we continue to believe that both sides still seem to be moving towards a deal. Mr Trump believes that being unpredictable gives him an advantage over his negotiating counterpart, but he still needs to meet with his counterpart Mr Xi to look presidential and bolster his 2020 re-election campaign.

The best course forward is to wait for the formal conclusion – or breakdown – of the trade negotiations in the coming days. We believe that the most prudent stance right now is to monitor the situation closely and refrain from over-reacting.