Equities Still on Thin Ice Despite Trade Truce
Summary: The ongoing tug of war between the competing themes of trade optimism, central bank easing and the continuing deterioration in global growth is set to resume centre stage this week. For this week at least it looks like a modest squeeze higher in risk assets can continue and trade optimism will win the tug of war. But trade truce aside, with the SP500 flirting with all-time highs again the risk/reward for risky assets in general remains skewed towards the downside as Q3 earnings begin.
With a feeling of deja vu, the US and China have once again put escalating trade tensions on ice reaching a “phase one” deal that has been ratified with just a handshake at this stage. President Trump and Chinese President, Xi Jinping, are expected to formally ratify the phase one deal, signing the document at the APEC summit in November.
As part of the phase one accord, the US will not be raising tariffs on Chinese imports this week and China have agreed to step up purchases of US agricultural goods and open their Financial Services sector more quickly, a promise we have heard many times before. Also included in the phase one deal is unspecified IP reforms and a loose currency pact.
As always, the devil is in the details and this phase one accord amounts to more of a confidence building exercise keeping hopes alive for an eventual more comprehensive trade deal further down the track. The fact that the two sides are continuing negotiations and this week’s scheduled tariff hike has been delayed is positive. The truce has helped to lift sentiment, and risk assets are rallying along with expectations that there won’t be any further escalation before year end. For this week at least it looks like a modest squeeze higher in risk assets can continue and trade optimism will win the tug of war. But the partial deal has not brought any meaningful concessions to the table and at its core represents a true can kicking exercise, the December 15th tariff increases remain a looming threat and previous off ramps in escalating tensions between the US and China have proved to be fleeting. When it comes to trade, sentiment can turn on a dime. With that in mind, by the end of the week with China GDP data released Friday likely to confirm the ongoing slowing growth momentum, the oppositional pull from global growth concerns may begin to assuage the “phase one” bounce.
Generally, most of the concessions provided by China in this phase one pact are minor in the grand scheme of things and largely match their own self interests. China does need tighter rules surrounding IP protection as this fits their own ambition of becoming a technology leader within the MIC 2025 plans. Their long-term goal of internationalising the RMB and also avoiding capital outflows also dictates a pact avoiding large currency devaluations suits their own interests. And when it comes to agricultural purchases, they have to be imported from somewhere!
Core issues remain
Ever present is the ongoing reminder that the frictions between the US and China go well beyond just trade. The thornier issues of industrial policy, state subsidies and enforcement of agreements reached remain unresolved and a comprehensive deal that truly levels the playing field is still a long way off, if ever. A partial deal will only provide temporary relief from long-term bilateral tensions. This is a long-running economic conflict and battle for tech dominance and hegemony. And no phase one deal will stop China from continuing their strategic push to become technologically advanced and outpace the US as the productivity gains required from advanced tech and AI and the like is required to propel China from middle income to high income country as they rotate from a low-end manufacturing and export driven economy towards domestic consumption and services drivers. The battleground through which this rift is enacted is ever expanding, as evidenced most recently by the NBA clashes, and the relationship has fundamentally changed.
Big picture we need to be aware the road ahead is long and winding which calls into question the sustainability of of the present trade optimism induced rally. A pause on tariff hikes will not have a meaningful impact on growth. There is nothing on the horizon to suggest that already implemented tariffs will be rolled back anytime soon and tariff escalation remains a real risk. The uncertainty remains and that means the interim deal will not be enough to reignite confidence and investment amongst corporates that would be needed recalibrate global growth expectations higher.
Slowdown Predates Trade War
Another key takeaway here is that the present slowdown pre-dates the trade war. We are not in the clear just because of some mini agreement that brings little substantive change. When we cut through the noise and trade headlines to the economic data, the message is clear that the global economy continues to slow. We don’t rule out a stabilisation in growth in 2020 but believe it would be too early to position for, risks still remain, and further stimulus will be needed.
Trade aside, other key drivers this week will be the data dump from China which is likely to remind investors of the ongoing broad slowdown in economic activity in China. Exports are set to contract further as global demand has faltered, and GDP growth continues to track lower pressured by structural challenges and trade woes. Closer to home the Aussie jobs data will be crucial. Labour market slack is a key impediment to wage growth and hence the consumption outlook, so crucial in assessing the forward policy pathway for the RBA. Also, of concern is the fact that forward looking indicators such as job adverts and vacancies continue to indicate further weakness is yet to materialise in the labour market.
The week ahead also brings a myriad of Fed speak reviving the ongoing debate with respect to an October rate cut from a divided Fed. US Q3 earnings will commence with 10% of S&P 500 companies reporting this week. As we have said many times, consensus estimates remain optimistic against a backdrop of elevated uncertainties, margin degradation and the lagged effect of tariffs hikes. The next big test for markets basking in trade optimism will be the realities of companies reporting a more sombre outlook into 2020 which is not in keeping with the consensus expectation of a recovery in FY2020 EPS growth. We also still see significant risk of an earnings recession in coming quarters. US growth has peaked, the dollar remains strong, and last year’s cycle peak in earnings growth make for some formidable base effects. With the S&P 500 flirting with all time highs again the risk/reward for risky assets in general remains skewed towards the downside as Q3 earnings begin.