With new rounds of Sino-US trade negotiations underway, the atmosphere for the meetings seems to have improved.
We see three potential outcomes:
- China and the US agree by March 2019 (when the tariff truce is due to expire) to settle all major issues and tariffs are rolled back (10% probability)
- Trade talks stall or are derailed; the 10% tariff on the USD 200 billion of Chinese exports to the US rises to 25% and President Trump threatens to levy 25% tariffs on all imports from China (20% probability)
- Negotiations continue beyond March with no further tariff escalation (70% probability).
On the Chinese side
China is accelerating its opening-up and reform processes. In recent months, the Chinese authorities have approved significant investment deals, allowing several multinational corporations to set up wholly-owned factories in China or acquire majority (75%) stakes in their Chinese JV partners. Recent policy action suggests that the government wants to be seen not to be delaying or reneging on promises to further open up markets to overseas investors. For example, while rules that will allow foreign life insurers to own majority stakes in their China ventures have yet to be finalised, negotiations for such approvals have gone ahead.
This could indicate that China has finally understood the ‘promise fatigue’ among foreign investors and is trying to correct the problem. The recent moves complement other measures to address US complaints about China’s protective behaviour. They should help to improve the atmosphere at the trade negotiations.
As for the US
The Trump administration has been steadily increasing pressure on China through tariffs. However, it is now seeing the economic and political costs of the trade dispute. Import prices on intermediate goods have risen, squeezing profit margins for US producers; demand from China has fallen as a result of retaliatory tariffs; hits to Chinese growth stemming from the trade dispute are resulting in less demand for US products. Tellingly, as an example, Apple has cited weakening Chinese demand as it revised down its quarterly revenue forecast, and investors have generally sold off shares in companies with meaningful exposure to China.
The impact of the trade dispute appears to be showing up in business survey data. The ISM purchasing managers’ index for the manufacturing sector fell by over five points in December. While this is still consistent with continued economic expansion, the drop is larger than any seen in the 2014-2015 corporate profit recession and the index now stands at its lowest in over two years. The new orders sub-index has fallen even more sharply and survey respondents have indicated that tariffs are weighing on demand and prompting longer-lasting concerns about input costs and sourcing.
All of this suggests that the administration is running out of policy space to apply meaningful further pressure on China through tariffs, especially against the backdrop of sharp US equity market declines and signs of decelerating GDP growth.
The renewed Chinese efforts to accelerate market access and reforms could pave the way for Washington to postpone further tariff increases. However, the issues of Chinese intellectual property and technology transfer practices would remain a sticking point. But the progress on market access and steps to address the bilateral trade deficit might allow December’s tariff freeze to be extended beyond March.
While we feel more confident that further escalation will be delayed, overall uncertainty remains high and adverse outcomes are still possible given the president’s long-standing belief that China has been unfair on trade, market access and intellectual property practices and bipartisan support in Congress for a harder line.
US Trade Representative Richard Lighthizer is running point on the negotiations and shares many of the president’s views on China. Recent media reports have suggested that Lighthizer is sticking to a tough negotiating position and has even prevented the president from accepting what he believes to be half-measures from China.
possible scenarios and implications: The base case
Our base-case scenario is that of negotiations continuing beyond March with no further tariff escalation. If it plays out, and if China’ growth recovers modestly after bottoming out in Q4 2018 (as we forecast) and the pace of Fed rate rises slows this year, there could be room for Chinese assets to bounce this year.
Trade-war concerns and diverging growth between China and the US accounted for much of the weakness of Chinese stocks and the renminbi in 2018. These forces could reverse as trade war risk eases and macroeconomic risk turns into microeconomic tech sector risk.
While uncertainty about the trade talks abounds, it is worth thinking about the turning point for this base-case scenario.
Early March is not only the deadline for the trade talks, it is also when MSCI will decide whether to raise the inclusion factor for Chinese A-shares in its emerging market index to 20% from the current 5%. The odds are high that it will as China has addressed international investor concerns by scrapping the Stock Connect scheme’s daily quota and by reducing the number of stocks suspended from trading to a couple of dozen from hundreds. Beijing also intends to expand Stock Connect to other markets, notably London.
If the MSCI decision coincides with China’s economic recovery, Chinese stocks, China-related assets and the renminbi could rally significantly.
Chinese bonds, which gained almost 8% in renminbi terms and about 2% in US dollar terms last year, might also do well. China’s monetary easing will likely continue; Bloomberg/Barclays will include all Chinese government bonds and policy bonds in their Global Aggregate Bond index from April and other index service providers may follow. This should trigger more sovereign and private-sector buying of onshore bonds.
The worst-case scenario
A collapse of the talks would trigger another round of risk-off trades. The renminbi would likely fall beyond the threshold of seven against the dollar and the hit on global investor confidence would probably trigger capital outflows from emerging markets, tighten liquidity and hit risky assets.
But there could also be a surprisingly positive impact after any knee-jerk adverse reaction. An intensified trade shock could force Beijing to step up its policy stimulus to protect growth even at the expense of its debt reduction and reform efforts. Such a reflation effort may not be structurally positive for the economy in the long term, but the short-term liquidity effect could strongly boost Chinese and China-related assets, including commodities.
 See “Chi Flash: Sino-US Trade War: Truce for Now But Risks Have Muted”, 3 December 2018.