In the past weeks, when we wrote about economic green shoots and the increasing likelihood of a global cyclical recovery, we always had the US and China striking a trade deal before the summer at the back of our minds. This scenario has not gone, but it certainly has become less probable since the trade negotiations between the US and China broke down last week. Most of the weakness in the global economy over the past few quarters can be explained by trade worries. A longer period of uncertainty will keep pressure on trade volume growth and capex intentions, particularly in Asia, making an economic recovery more difficult.
If a deal becomes less likely, however, the probability of more China policy stimulus will increase while the chance of a less dovish Fed and ECB will decrease. Mainly triggered by the escalation of the trade conflict, but also driven by some of our quant input that suggests that investor positioning in equities is still high (see graph), we reduced our exposure to global equities from neutral to a small underweight. We also closed our small overweights in emerging markets equities and local bonds.
What a difference a tweet makes!
In the weeks before President Trump announced his new tariffs on Sunday, 5 May, the global economy had just started to show some cautious signs of a growth pick-up. In particular the data from China were encouraging, with credit growth, real estate investment and imports all printing better numbers. Elsewhere in Asia and in Europe data were more mixed, although there was some improvement compared with the very weak data of late 2018 and early this year. The green-shoots theme caused a rally in global equities between the last week of March and the end of April. And not even the spike in oil prices, due to the end of the Iran import waivers, could spoil the party. Only EM assets struggled, as the higher oil price caused some doubts among investors about the sustainability of low inflation and easy monetary policy in the emerging world.
So what does this setback mean?
We have always said that the trade deal we were expecting before end-June would remove some uncertainty for Chinese exporters, Asian manufacturing businesses, European capital goods producers and global trade in general. However, a full normalization of trade relations reverting to the pre-2018 situation has always been unlikely. Still, a reduction in uncertainty would have helped to stabilize global trade growth to low single-digit levels and created room for a modest economic recovery in both Asia and Europe. After what has happened in the past weeks – the US raising tariffs on USD 200 billion of Chinese goods from 10% to 25% and China retaliating with higher tariffs and reverting to last summer’s stance – the prospects of a meaningful bilateral trade agreement have deteriorated. It is still possible that we will see a deal before the end of June, but it has become more likely that the negotiations will be extended well into the second half of the year.
China pragmatic; US still aiming for a deal
Behind the rhetoric from both the US and Chinese governments, we still perceive a certain appetite for a deal on the US side and a high degree of pragmatism on the Chinese side. The US attitude is reflected in recent comments made by President Trump, who insists that a deal in the coming weeks remains possible. Given the relative strength of the US economy, one would think that he has time to negotiate for longer to strike a better deal. Still, a serious market correction less than 18 months before the 2020 presidential elections would increase the likelihood of an economic downturn right before voters cast their ballots. China’s pragmatism, which has been a constant factor throughout the whole trade conflict, remains predominant. This is most visible in the retaliatory steps that, again, have been minimal and certainly not aimed at escalating the conflict further.
The Chinese authorities need a deal to stop the manufacturing downturn that is complicating their long-term efforts to gradually bring the pace of domestic demand growth to a more sustainable level that better fits the country’s demographics and level of leverage. They do not want to be forced into much more aggressive economic stimulus, which would jeopardise the progress made in their deleveraging campaign aimed at reducing financial system risks. All this means that there are still good reasons for both sides to continue working towards an agreement. But the visibility for investors is low. We do not know what the concrete problems still are and where exactly the two sides have clashed. The negotiations will continue and we should be prepared for a longer and perhaps more volatile process.
Longer period of trade uncertainty
So the new base-case scenario is one of a longer period of trade uncertainty. This explains why risky assets have sold off and why emerging markets have clearly underperformed developed markets. In this environment, the global growth recovery that we were expecting might materialize slightly later. At the same time, we should not underestimate the Chinese policy stimulus, which has started to be reflected in the Chinese data, as this should boost both consumption and fixed investment growth in the coming quarters. In a scenario of prolonged trade uncertainty, the Chinese authorities are unlikely to reduce the stimulus measures any time soon.
Recent scepticism among investors about the Chinese recovery is, in our view, not fully justified by the recent figures. Data tends to be weaker in April than March (a late New Year effect) and not all key data have been that bad. Industrial production growth was clearly weak, but this number is highly sensitive to global trade expectations. At the same time, import growth, which is more a reflection of domestic demand, turned positive and was much better than expected. And more importantly, broad credit growth stayed flat at 8%. Meanwhile, property investment also remained strong.
Less risk exposure
But despite the relative strength of some key figures recently, we must acknowledge that, due to the volatile trade talks, most trade- and manufacturing-related data in China and its Asian suppliers will likely remain weak in the coming months. This will make it difficult for emerging market growth momentum to improve and will probably prevent a meaningful recovery in European manufacturing exports and global capex in the coming months. These considerations have been key in our decisions to reduce risk in our tactical asset allocation and, more specifically, to reduce exposure to emerging markets.
Apart from these fundamental factors, we have also taken into account the negative impact of the trade talk disappointment on investor sentiment. We perceived this to be vulnerable anyway, given the high positioning in global equities and the low levels of market volatility. It was mainly for these more technical reasons, that we had luckily already neutralized our equity overweight a week before the trade surprise occurred.