Posted on: 09 May, 2019
There is a huge bump in the road that must be overcome by both the US and China’s trade representative this week, after the discontent by the Trump administration over China looking to backtrack on the majority of conditions pre-agreed as part of the grand trade deal being negotiated.
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In the world of finance, a strategic plan of engagement dependable on anticipation of scenarios helps you to become more responsive, in other words, you know what type of movements could be expected vs reactive, which is more about acting without preparation on what the potential repercussions of a particular event would be. Scenario planning is in large part of an adaptation and generalization of classic methods used by military intelligence that have morphed into models of preparation to trade financial markets. In this report, I will analyze and deconstruct the potential scenarios that can be expected in this week’s crucial US-China trade talks.
There is a huge bump in the road that must be overcome by both the US and China’s trade representative this week, following the discontent by the Trump administration over China looking to backtrack on the majority of conditions pre-agreed as part of the grand trade deal being negotiated.
The modifications in many of the agreed aspects of a deal led President Trump to tweet of an imminent hike in tariffs to 25% on $200bn by this Friday unless China makes good its end of the deal by reverting back to the US demands. These include changes of domestic laws that will look to mitigate familiar issues orchestrated by the Chinese, including the steal of U.S. intellectual property and trade secrets, forced proprietary technology transfers, exchange rate advantage via a manipulated Yuan.
Secretary of the Treasury Mnuchin and top trade representative Lighthizer have reaffirmed the hard-line stance by the Trump administration to enact the planned hiking in tariffs to China’s imports this coming Friday, further exasperating markets, which have been in a state of ‘true risk off’. There was no mention of Trump’s retaliation with regards to yet another increase in tariffs of 25% on other Chinese imports of USD325bn, which Trump has mentioned via Twitter to add further pressure onto China.
Trump’s drastic change of rhetoric towards China seems to reflect his re-ignited optimism in the US growth path, a marked improvement in financial conditions and broad-based bipartisan endorsement to keep a firm hand on the Chinese. However, at the same time, a similar dynamic seems to be playing out in China, where there has been evidence of green shoots again in the economy, which gives the government of President’s Xi further room to toughen up their stance on the trade talks.
By reading news outlets based in Mainland China ever since the incendiary tweets by Trump over the weekend, the views have been largely defiant. The toughest language came from the People’s Daily’s WeChat account on Tuesday: “Things we think are advantageous for us, we will do it even without anyone asking” adding that “Things that are unfavorable to us, no matter how you ask, we will not take any step back. Do not even think about it”.
Similarly, the tone by US President Trump via Twitter remains confrontational, far from setting up the stage for a conducive and respectful resumption of the negotiations with the Chinese. Trump tweeted: “China has just informed us that they (Vice-Premier) are now coming to the U.S. to make a deal. We’ll see, but I am very happy with over $100 Billion a year in Tariffs filling U.S coffers… great for the U.S., not great for China”.
There is a sense that both countries are walking a very tight rope as the US demands it’s time for China to commit to reforms amid the refusal to accept verbal assurances. However, as the South China Morning Post reports, “China is reluctant to make further structural reforms, with some government advisers in Beijing holding the belief it would be better to accept higher tariffs than make ‘suicidal’ changes to country’s economic model.”
The Chinese trade representatives convoy arrives in Washington this Thursday for what’s set to be some very crucial talks. The aim is for both sides to bridge the current impasse and find a temporary compromise that prevents the enactment of further tariffs on Friday. There are multiple scenarios to prepare for, which is what I will deconstruct in the next section of this preview. From the most risk-friendly to the worst risk-averse, each outcome is expected to spur specific price dynamics.
We’ve reached a point in the negotiations where the art of brinkmanship, that is, not showing weakness to your opponent is going to be critical. Will Trump be willing to hikes tariffs and risk a meltdown in equities and a slide in ratings ahead of the 2020 re-election campaign? Is Trump willing to accept this pain? Late last year he wasn’t, which led to the temporary trade truce that further anchored the equity rally we've seen this year. How about China, how confident are they to weather a slowdown in the economy through more stimulus without a trade deal? The assessment of what side has got more to lose will be cardinal.
NOTE: I will not be spending much time in a scenario that I find it, at this stage, simply irreconcilable. I am referring to an outcome where the US and China put all their differences on the backburner and work around the clock so that by the end of the week, the anticipation is that a deal is done and dusted. This scenario, which may have sounded realistic last week, would be drastically irrational and completely incongruent based on all the rhetoric we’ve heard from both sides this week. I wish I was wrong, which would then translate in a quick erasement of all the losses experienced this week in equities and some more (lower Yen), but I cannot envision it.
A conceivable scenario, even if not the base case, is that by the end of talks today, we get a sense that the pre-existing timeline of a deal, which was supposed to be just a matter of weeks, is met. What this would imply is that the US and China can leave behind their differences and all of a sudden agree on most of the aspects currently outstanding. This would be then reflected via positive headlines where both parties agree to finalize what’s already a verbal deal in coming weeks. Trump would then put on hold the increase in tariffs that come into effect this Friday. Before last weekend’s pivot by Trump, one would have thought this was a plausible scenario, but the new tactic by Trump to intimidate his opponent has definitely caused a spin in the perception by the Chinese, who will not accept to be humiliated as will prove a sign of weakness.
An immediate deal would essentially make one side be seen as the weakest, expose their credibility as they will have to back down in a considerable number of factors they currently stand against. Even if I assign slim chances, if this event were to occur, I believe it would be China that reverses its positioning. In terms of the influence, it’d have in markets, expect major ‘true risk on’ swings, with the Australian Dollar and the Yuan the currencies most in demand, while the Japanese Yen would suffer an enormous amount of selling pressure. The USD is not expected to go through a round of selling as aggressive as the Yen even if it should still suffer against the likes of the Canadian Dollar or the Kiwi. This environment should bring back stability in the volatility regime, which would then promote the USD as a vehicle to play carry trades. In terms of equities and bonds, the former would spike taking aim at closing this weekend’s downside gap, while bonds would be under strong supply.
I really believe that the damage has been done, judging by the rhetoric used by the US. That's why this is my central scenario. At a rally in Florida just minutes ago, Trump treated the markets with yet another hint that China is to blame by riddling with the trade agreement draft. Trump said: "By the way, you see the tariffs we're doing? Because they broke the deal. They broke the deal. So they're flying in, the vice premier tomorrow is flying in — a good man — but they broke the deal. They can't do that, so they'll be paying." Trump added that the United States "won't back down until China stops cheating our workers and stealing our jobs."
China argues they believed the US was ready to make concessions. We’ve quickly shifted into a ’game of chicken’ with no clear end in sight, that’s how I see it. It’s become a chess game with no party wanting to lose face and credibility back at home, but at the same time, they are aware that these are high stake decisions with enormous ramifications for financial markets. So, we might end up with a situation in which both countries recognize the need for an eventual deal at a future tentative date, even though not enough progress is made to avoid the hike in tariffs. Trump may opt to only partially increase tariffs, be more selective on the products applied so that it is not seen as a punishment as harsh as initially planned. Regardless, the Chinese would be forced to implement a proportionate retaliatory response with immediate effect too.
The doors for a potential deal, however, will be left partially opened as both sides refuse to completely rule out, knowing well that the announcement about the cancelation of future talk would wreak havoc the markets. So, in this scenario, a soft tariff hike (less than the extra 15pp expected) with an admission that both sides are still ready to continue the negotiations upon further consultations with their own parties, would still cause markets to interpret the news as a negative input as the symbolic action of raising tariffs is seen as a really problematic outcome leading to potentially months of delays before a deal.
The bearish movements in the Australian Dollar or Chinese Yuan would be quite sizeable the moment the market picks up on this idea that no deal is to come anytime soon and tariff hikes will be enacted. The amount of volatility is likely to be conditioned by the percentage hike in tariffs and to what degree/extent an eventual deal will have to be delayed. The expectation of a delay beyond June/July will test the nerves of the market, while the lack of details about the timeline on when both sides will come back to the drawing table will definitely have the worst implication for risk assets.
While I wouldn’t be placing that high odds for this outcome to materialize as the logic that to me stands the most sense is that both sides recognize the high stakes if talks breakdown. However, if Trump goes ahead with the intent to impose the full extent of the 25% increase in tariffs, it will not only follow an immediate retaliation of the same proportional measures by China, but it may lead to a re-assessment of the pros and cons, in which the final conclusion is that the former outweighs. It may snowball quite rapidly from the moment one side gives enough indications that they’ve reached unaddressable differences. The US would likely impose further tariffs on USD325bn of imports, and things could get quite ugly from here.
This would be a major gamble by both sides in hopes that their respective economies will be able to weather the storm of what is likely to be a severe increase in the headwinds and a significant downgrade in the global growth outlook. This scenario would send shockwaves across the market, with the VIX index likely to fly into the 30-35 vicinity, the S&P 500 retracing a decent chunk of this years’ advancement, while the Aussie and the Yuan would be decimated, the former trading sub 0.69 most likely to establish a new trend regime sub 0.70c while the USD/CNH will likely be used as an active tool to gain back competitiveness by breaking 7.00.
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