Where were we?
Up until Friday May 3, the financial markets were operating in a very different spirit in regards to bullish and positive sentiment. After what had been a brutal Q4 for global equities – with some single stock names easily down more than 50%, the S&P itself pulled back by about 20% – the bounce back had been V-shaped and magnanimous in its consistent trend upwards.
To get some context of this, on Friday May 3’s close, the S&P, Nasdaq100 & CSI-300 were up +19%, +25% and +30% respectively, in a little over four months. Those are stellar returns over an entire year, let alone four months. As we repeatedly called out though, the pace was just not sustainable. We had also been shocked at how the market was pricing in +105% of a US-China trade deal.
Then came Trump’s now infamous tweet on Monday May 6 (or Sunday May 5 in the US) where he gave the Chinese a week to settle on what was (from the US perspective) supposed to be almost a done deal. Whilst Chinese equities sold hard on that same Monday, markets as a whole held up relatively well in anticipation of a capitulation by China or some kind of extension of the deadline by the US.
The deadline came and went, with the net results of the markets seeing a much tougher China than had been anticipated – both in regards to retaliation, but also in terms of the language China is now using, which is perhaps more alarming for the US and general risk-on assets globally.
And if that was not the worst, we now have China tech icon Huawei under the crosshairs of the US administration (remember nothing has been proven in the court of law), with potential tit-for-tat consequences cascading into individual companies, currencies and commodities. We are now seeing the possibility of rare earths or the Chinese yuan being ‘weaponised’ in what could potentially be a new cold war and one that could divide the world broadly into two camps – a pro-China camp and a pro-US camp.
Complications
Trump’s tweet complicated matters for China’s leadership, and how they must act in front of 1.6 billion people. By airing the details of the negotiation, the US administration have raised the bar of difficulty for China to be conciliatory – the US will have to backtrack on this strategy, if they have any hopes of getting the Chinese to the table.
Emerging markets will tend to get hit hardest, and Chinese equities will struggle to maintain their gains for the year
The noise between the US and China commands the airwaves and it makes Trump look like a strong man to his base of supporters, the tough guy for the American people. It also takes away airtime from his Democratic opponents. US-China trade relations is one of the few areas that the Democrats can never attack Trump on. It’s one of the few areas where they agree things need to change, however, execution of that is a different issue.
Another unintended consequence of no potential trade deal is that Trump gets a bigger stick and lever for another fiscal stimulus round in the US. Not to mention that the headwinds caused by escalating tariffs and showdowns would keep the Fed at best on neutral, yet very far from hawkish (currently the probability of a cut by the Fed is around 73%). Therefore a much bigger infrastructure bill, or subsidies for US industries is increasingly gaining a higher probability and could be a short-term positive for market sentiment.
The Middle East
Long-term equity investors need to realise that timing the market is – at best – a break-even exercise. Part of the reason you pay long-only fund managers is for the discipline of holding onto well capitalised, positive cash flows generated by superbly run companies. Assuming we are on the tail end of a global business cycle and long overdue a recession, the traditional sectors of staples, utilities and healthcare should outperform cyclicals such as industrials, financials, materials and consumer discretionary.
Good long-term hedges may include the semi-conductor index SOX which provides exposure to US-listed companies in that industry. This index pulled back by over -80% in the dotcom crisis and close to -70% in the global financial crisis. Other potential instruments to buy if tensions escalate further are the rare-earth ETF REMX, USDCNH (expecting a break of 7.0) and puts on Chinese equities (expecting them to sell-off).
General Asian FX could face a lot more pressure, as a yuan devaluation would be very deflationary and trigger a race to the bottom currency wise. Energy would also suffer in such a scenario and we could easily see a -10% to -15% pullback in oil if we had a big sell-off in equities.
It is worth bearing in mind, a repeat of 4Q18 in the US is more unlikely now given that, unlike in the 4Q18 we now have a much more dovish Fed & ECB.
50:50 view
Whilst our house view has now decreased to a 50/50 deal or no deal scenario (from 60%/40%) – in a no deal scenario we likely still have a situation of US equities outperforming versus the rest of the world. Emerging markets will tend to get hit hardest, and Chinese equities (despite state-owned enterprise support) will struggle to maintain their gains for the year. Bond yields should structurally move lower – as we are not exiting the QE-synthetic world anytime soon – which means yields will make new structural lows surpassing even the crazy levels we saw in 2015/2016. It also means we can potentially expect a lot more stimulus out of the US and China, and generally fiscal stimulus around the world.
Long-term equity investors need to realise that timing the market is – at best – a break- even exercise
However, things are exceptionally fluid and the only consistent thing about Trump is his inconsistency. He is a walking-talking geopolitical event and there is a pathway where he could reverse his views on China, seal a deal and claim victory before moving onto his next focus. In many ways, he has done a lot more to even-out the playing field for the US and the rest of the world with China than any sitting US president ever has. The fact that he recently pushed the auto tariffs talks with the EU and Japan by six months and also pulled back the steel tariffs on Canada and Mexico, suggests that the door to the Oval Office is still open. And whilst China has postured strongly that it is not afraid of playing hard ball as well, we are seeing some signs of openness as well on their side.
One thing that is for sure, given the current sentiment, a further deterioration seems to be the consensus expectation (sentiment is quite poor), which means a resolution on a trade deal would be a hugely positive surprise.
Kay Van-Petersen, Global Macro Strategist, Saxo Bank
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