Friday, 17th of January 2020
”Maybe they have nothing else to do in America but talk about me.”
– Vladimir Putin
The big news this week was ratification of the ‘phase one’ US-China trade agreement, which was signed to much fanfare at the White House on Thursday. Markets saw the deal coming, if not its precise terms, and rallied strongly in December after planned tariff hikes were scrapped. However, when the details were made public this week there was barely a whimper from investors, and the Chinese CSI 300 Index ended the day down -0.4%. In the 86-page text, China has pledged to buy $200bn more in US products than it did in 2017 (at the outset of the US-China trade war) over a two-year period. This is sizeable increase on the ~$120bn of purchases China made of US products in 2017. The $200bn fugure includes $78bn of manufacturing, $52bn of energy, and $32 of agricultural goods, as well as $38bn of US services (e.g., cloud computing, financial services, and tourism). However, the deal specifies that purchases “will be made at market prices based on commercial considerations” and will depend on “market conditions”. In other words, do not expect a sudden rush of policy-propelled Chinese demand. In addition to buying more US goods, China has promised not to manipulate its currency to boost exports artificially. This is something the country certainly did in the past but has not done for years as it seeks to rebalance its economy and become less reliant on external sources of demand. It is therefore not really a concession but was necessary for the US to agree to remove the country from its list of currency manipulators. Elsewhere in the agreement are promises to relax barriers to US agriculture and financial services and a pledge to toughen up IP protections and make it easier for foreign firms to seek recourse for patent infringement in Chinese courts (and without the mandatory disclosures of sensitive information). China also pledged to end forced technology transfer, a commitment already made under the WTO but one that it has regularly breached. Finally, the deal contains a dispute settlement mechanism with regular meetings between top officials to address purported violations. Should meetings produce no resolution, the aggrieved party has the right to impose punitive tariffs without a “counter-response” from the other so long as such actions are taken in ‘good faith’. In return for China signing up to the deal, the US has agreed to reduce tariffs from 15% to 7.5% on $120bn of Chinese goods.
That most US tariffs will remain in place when the deal comes into effect in a months’ time helps explain the muted market response. Moreover, although the list of concessions looks impressive at first glance, the most contentious matters – namely, the cybertheft of US IP and technology and China’s widespread use of distortive subsidies – have been kicked into the long grass (or until after the 2020 US Presidential Election at least). To be sure, there are benefits to (temporarily) reducing trade tensions and some tariffs between the two superpowers, and the confidence boost has already been felt in markets. But many of the promises made by China to secure this deal, particularly the additional purchases of US goods, may be unworkable in practice. Others will only have long-term economic benefits that continued trade uncertainty will more than offset. Finally, the phase two talks which are due to begin soon will be tough and could drag on for years, while the barriers between the two countries remain a drag anchor on global growth. Therefore, although investors have earned a reprieve in the US-China trade war, we are by no means out of the woods yet. This is a subject that will continue to fill the pages of the Bedrock newsletter for quite some time.
The lingering uncertainty in US-China trade relations, made worse by the ongoing disputes over Huawei and Hong Kong, is but one reason we have chosen to maintain our portfolio hedges through Q1. Other risks to the outlook for equities include the possibility of a US trade war with Europe (which is clearly in Trump’s sights), a liberal Democrat like Bernie Sanders winning the 2020 election, a likely showdown between the EU and UK over Brexit, and the threat of a conflict between the US and Iran in the Persian Gulf. For the most part, these are tail risks which do not, even collectively, present a good reason to exit equities altogether, at least not when volatility is so compressed that protection is cheap to acquire. But we are mindful that a substantial sell-off when the bullish mood takes a turn is a distinct probability, given the strong rally in 2019 and with short interest having evaporated to its lowest level since before the market panic of Q4 2018. There is also the medium-term risk that global growth, which has stabilised above recessionary levels in recent months, fails to move higher.
On the growth front, there was mixed Q4 data out of China this week which shows an economy growing at its slowest pace in 29 years, albeit still at the staggering and highly dubious rate of +6.1% YoY. The data dump did include some green shoots, for example industrial production expanded +6.9% YoY, but it also had some red flags, such as housing sales by floor space which were down -0.1%. Fuelled by a massive credit expansion, housing has been a volatile asset in China but now makes up 25% of GDP. A housing recession could be a serious drag on economic activity in the months ahead even if the threat of additional US tariffs has been postponed for now.
Elsewhere in EM, the Russian President Vladimir Putin announced a major constitutional shake-up this week. The planned changes are being touted by United Russia as a means to modernise the country’s institutions and decentralise power. Conveniently, however, they also create new positions into which Putin can move that do not come with term limits or other awkward democratic hangovers. The reforms will change the balance of power between the role of the Russian President and that of Prime Minister, with the former downgraded in favour of latter. In addition, more authority will be handed to the State Council of regional governors, and the head of which is one position along with the new Prime Ministerial post that may interest Putin. Whatever his title at the end of the process, the man at the top of Russian politics will not be going anywhere anytime soon of course. That is one certainty in an otherwise turbulent world.