Friday, 10th of May 2019
“Those who have knowledge, don’t predict. Those who predict, don’t have knowledge.”
– Lao Tzu
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Equities have suffered this week as an escalation in US-China trade tensions took investors by surprise. Indeed, the S&P 500 has had its worst week since the depths of the sell-off in Q4 when a confluence of geopolitical factors, softer data in Europe and China and an unexpectedly hawkish Fed drove a flight to safety amid thin liquidity. Previously, there had been a growing sense of optimism that the two superpowers were on the verge of striking a major agreement to resolve their destructive Trade War, and a positive outcome had been more or less priced in by the market. However, in a series of tweets on Sunday afternoon, President Trump hinted that all was not well in the latest round of talks in Beijing and threatened to significantly increase US tariffs on China. The following morning, the leaders of the US delegation confirmed that punitive tariffs on $200bn of Chinese goods would rise from 10% to 25% on Friday. (This has since been revised to include only those goods shipped from China on Friday, giving the Chinese roughly a fortnight before their products arriving in the US will be subject to the levies). In addition, 25% tariffs on the remaining $325bn of Chinese goods imports would be prepared for implementation should China take counter-measures and trade talks collapse.
The US trade representatives accused China of backtracking on commitments made at earlier stages of the negotiations, particularly over the sensitive issues of weak foreign IP enforcement and forced technology transfer. They explained that Chinese officials, both in Beijing and in correspondence over the weekend, had sought textual changes to all seven chapters of the 150-page draft agreement. (The pushback appears to have come after chief Chinese trade negotiator, Liu He, brought the draft back to Beijing and opened up what were fairly abstract promises to technical scrutiny from a wider range of officials.) Moreover, US trade negotiators were unhappy that the Chinese side were unwilling to enshrine the promised policy changes in law and continued to favour regulatory and administrative actions instead. Shepherding legislation through the National People’s Congress is a laborious process and could invite a confrontation with vested interests and hawkish policymakers opposed to the deal. However, the US are well aware that actions that are easy to take are also easy to take away, so enforcement has been squarely in their sights from day one.
Even if China caves in to US demands and falls back on its previous position, how to phase out tariffs on Chinese goods to ensure compliance remains a stumbling block. The agreement will require China to make a host of legal and regulatory changes that will take time to finalise and implement in full. Before this process is complete, the US is loath to abandon its position of relative strength having expended much political capital raising tariffs and creating the necessary leverage to bring China to the negotiating table. Should the US cut tariffs too quickly, China may begin to drag its feet or simply decide to renege on aspects of the deal in all practical terms at a later date (potentially under a different US President with less mercantilist instincts). However, China does not want to implement painful structural reforms and pass politically-costly legislation during an economic downturn in part caused by deteriorating trade relations with the US and get nothing in return apart from promises to reduce (most) tariffs at the end. As such they want all tariffs to be removed (and quickly) as a condition of the agreement. Put simply, there is very little trust in the US-China relationship and this could yet cause negotiations to collapse. A Chinese delegation headed by Liu He arrived in Washington today for further talks, but do not expect a major breakthrough: a ‘beautiful letter’ from Xi to Trump won’t clinch the deal.
In large part, the rally in global equities this year has been driven by investor confidence (bordering on complacency) that a major US-China trade deal would soon be done. Therefore, it is no surprise that when reality hit, it hit markets hard. Going forward, however, we believe that economic fundamentals are supportive for equities, particularly in the US where labour markets are smashing records without spurring inflation and there are few signs that slower growth means a recession is imminent. We have previously argued that markets were due a correction given the strength of the rally this year and bought puts to cover a portion of our equity exposure towards the end of Q1. We believe the downward move this week could yet continue and short-term volatility is a clear risk going forward. However, coming out of an earnings season where three quarters of S&P 500 constituents beat consensus expectations, buying dips makes more sense than selling tops against the present backdrop.
Another geopolitical flashpoint with the potential to make waves in markets going forward is Iran. On Wednesday, which marked the one-year anniversary of the US decision to pull-out of the Iran nuclear agreement (or JCPOA), the Iranian leadership announced that they would suspend aspects of the deal and begin to stockpile enriched uranium once more. They also issued an ultimatum to the remaining signatories, giving them 60 days to find a way to protect Iranian banking and oil industries from US sanctions. Should they fail to do so, Iran plans to abandon another key commitment under the JCPOA and begin enriching uranium beyond the 3.67% level required for reactor fuel. The European powers have rejected the ultimatum and have urged Iran to comply with the agreement. The UK, France and Germany have been cooperating to set-up a transactions channel to allow exchanges with Iran via an SPV called Instex, bypassing the US-dominated international banking system. However, it is not yet operational, and the Iranian economy has taken a nose dive in the intervening period: the Iranian Rial has lost 77% of its value since US sanctions were re-imposed, inflation is running at close to 40% and the IMF predicts that the economy will contract -6.0% this year after falling -3.9% last year. Despite the turmoil already afflicting Iran, America continues to ratchet up the pressure. In April, the US announced plans to end the sanctions waivers previously granted to a handful of countries which rely heavily on Iranian oil, while on Wednesday new sanctions on the Iranian industrial metals sector were imposed. These are big employers in Iran and factory closures will cause the government some concern.
The US maximum pressure campaign is a high-risk approach as it risks empowering hardliners within the Iranian regime who always opposed the Iran nuclear deal. Moreover, Iran may choose to strike back by attacking US interests, soldiers and allies in the region through its proxies in Lebanon, Syria, Yemen and Iraq. It is not clear whether the US aims to cause an uprising or force negotiations through its strategy, but they are not giving Iran a face-saving way out of the current impasse. The situation looks increasingly like a tinderbox to which Donald J Trump is holding a flamethrower.
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