Here Comes The Chinese Trade Deal

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by: Ivan Martchev
Summary

As the positive headlines on the Chinese trade front multiply, we have seen stock market action in January that is exactly the opposite of what we saw in December.

We’re now seeing relentless buying with every dip.

There will be a trade deal based on the realization that the domestic economic situation in China is precarious and the lack of a trade deal will make matters a lot worse for the Chinese economy.

Crude oil is the big driver of improving US trade balance.

As the positive headlines on the Chinese trade front multiply, we have seen stock market action in January that is exactly the opposite of what we saw in December: We’re now seeing relentless buying with every dip. I think it would be hilarious if the S&P 500 ends January near 2,800, which is where it started in December. (For those keeping track, the intra-day Christmas low was 2,346.56.)

The dark comedy here stems from the realization that there were a number of factors that were reinforcing each other in the fourth-quarter market decline, but none of them was economic deterioration in the United States, which in theory should be the driving factor behind any stock market action.

I have often said in this column that there will be a trade deal based on the realization that the domestic economic situation in China is very precarious and the lack of a trade deal will make matters a lot worse for the Chinese economy. Multiple media outlets reported that the Chinese made an offer in mid-January to go on a bigger-than-$1-trillion-dollar buying spree in a bid to eliminate the trade deficit by 2024.

I think this is a very good offer and one that will be the basis of a trade deal – no matter that the U.S. side wanted results much faster than 2024. The reason why the trade deficit has kept growing, despite the trade tensions and some added tariffs, is the strong economy in the U.S. and the fact that many key goods are no longer manufactured domestically.

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I believe that the U.S. trade deficit with China can be eliminated completely, as the Chinese have been employing a very clever trade policy – to the detriment of the United States. Since China is a hybrid economy, Chinese state buyers control where China buys from. The Chinese have been running trade deficits themselves (i.e., trade surplus for the partner country) with many countries they consider key partners, so that they can increase their political influence. If China is the #1 trading partner for South Korea, for example, Chinese influence in South Korea can increase while U.S. influence decreases, despite the sizeable U.S. military presence there. There are numerous other examples where China is the #1 trading partner and the Chinese buy more on purpose – so that they can be more influential politically.

On the other hand, because the Chinese could get away with this clever maneuver, worthy of masterful Sun Tzu disciples, the American side has been enabling this activity by tolerating it, that is until President Trump showed up. Both Republican and Democratic administrations are at fault here as neither President George W. Bush nor his successor President Obama did anything to stop this Chinese trade policy.

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It has to be noted that the trade deficit numbers in 2018 would be horrific in absolute terms (estimated to be $879 billion according to the Paterson Institute of International Economics), yet in relative terms things were a lot worse during the second George W. Bush administration, when the current account deficit as percentage of GDP hit 6%. That same number is 2.4% for President Trump.

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Crude Oil is the Big Driver of the Improving U.S. Trade Balance

If you said shale oil production helped the trade deficit, you would be correct. It is true that in a recession consumption tends to suffer so the flow of trade with China and the rest of the world shrunk in 2008, but the reverse of that is happening right now. Back then, crude oil was a much bigger trade deficit problem.

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Since U.S. shale crude oil production surged and is nearly three times the rate it was in 2008, when it took out its previous all-time high peak from 1970, its relative effect on the trade deficit became much less meaningful. Today, China is the largest importer of crude oil. For decades that spot was reserved for the United States. As the Chinese economy has dramatically slowed, as evidenced by the sharp fall in crude oil prices, confirmed by the sharp fall in industrial metals, the price of crude oil has fallen rather sharply.

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It is interesting to note that the rebound in the London Metals Exchange Index is much smaller than the rebound in the crude oil price since the December 2018 lows, both on a relative and absolute basis. That tells me that sentiment is driving the price of crude oil and not necessarily demand, since we are in the seasonally weak period for crude oil (September-March) and investors are positioning themselves for a trade deal. I do not expect the Chinese economy to turn around on a dime after a trade deal is announced, which I believe will happen within the 90-day period ending March 1, notwithstanding any extensions that would be possible if the parties are close to a deal but the details have not been hammered out yet.

That means that the rally in crude oil is a rally to sell, not a rally to buy.

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Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.