Twisting In The Trade War

by: SA Marketplace

News updates have come a mile a minute this week on the China-US trade front, and we end the week with more tariffs and a topsy-turvy market.

Where do we go from here? What should happen, what will happen, and what else matters?

A panel of Marketplace authors share their analysis on the developments and what they're watching for in the months ahead for this week's Market Guide.

By Daniel Shvartsman

In the pre-internet, pre-Twitter (TWTR) days, international negotiations were no doubt volatile, but they tended to be hidden from public view until the end result came out. Leaks would happen, rumors would float, but there was something about operating in a closed room with lower audience costs in the olden times.

That is not how the current negotiations between China and the US over a trade agreement are playing out. News seems to break early and often, some coming directly from President Donald J. Trump's mouth, or Twitter feed, at least. But the issues related to these negotiations have been building over a long time, and it seems like the impact of these discussions could likewise last for years or decades. So, we asked a panel of Marketplace authors to shed light on the near-term turmoil but also tell us where they're looking once this shakes out. The negotiation specifics have changed several times even since we asked our authors these questions Thursday morning, but we hope the analysis will have a good shelf life.

Welcome to The Market Guide! This weekly newsletter features our Marketplace authors zeroing in on one of the hot topics of the week. The Marketplace is our platform for authors to run services that provide research, guidance, and ideas to investors, and to lead investing communities. So, we thought this newsletter would be a natural way to share some of those ideas and guidance on specific topics. We'll also highlight related articles and must-reads from our authors over the past week, and any developments on the Marketplace as a whole. Here's last week's edition for reference.

This week's panel:

News is changing around the China trade talks on an intraday basis. What are the bigger issues investors should watch for as the near-term situation sorts itself out?

B&B Market: These trade talks have been front page news for about a year and a half at this point, but it seems we are far from making a deal. We had been in a truce with the Chinese since late December, and the truce was extended, which implied talks were going well. However, as of this week, things fell back, hard. Come Friday, the 10% tariffs imposed will raise to 25% on $200 billion of goods imported from China. I do not foresee this issue 'sorting itself out', rather it may, in fact, go on much longer than originally thought. I will continue to focus on the volatility seen within the Chinese markets, which have created some excellent buying opportunities, but on the other hand, it has also crushed those who already had positions. I still strongly believe that if the company is strong fundamentally, this should be a short-term opportunity.

James A. Kostohryz: Many people do not realize how vulnerable China's economy currently is. The rapid build-up of debt in the corporate, household, and state/local government sectors in the past few years has been almost unprecedented in world history. Any significant slowdown in their economy - say, from 6.0% growth to 4.00% - would trigger a wave of defaults and a crisis in their financial system. This is the most important big-picture issue that investors should have in mind as they evaluate the Chinese side of the US-China trade negotiations.

Joseph L. Shaefer: The biggest issue investors should watch for is capitulation by the United States in allowing all the changes China has just submitted ("after" agreeing to the original agreement of a week ago.) Their words bear little relation to the actions they will take. The result might be slightly better profits from Chinese shares but will mean lower profits for US firms doing business there.

Eric Basmajian: In my opinion, the trade issues are largely overblown. There will be constant headlines over the coming weeks but hanging on every word from the President’s Twitter handle is not a great way to invest. Investors should have an outlook on broad economic trends, something provided at EPB Macro Research, and use the volatility from the trade headlines to enter/exit positions. My expectation is that after the issues are resolved, after major market volatility, the economic situation of both countries is largely unchanged as a result of the tariffs. The economic changes that occur between now and the end of the trade war will more than likely be a result of normal economic cyclicality.

What do you think 'should' happen between China and the US, given the current players and outlook?

B&B Market: Many believe that this trade war never should have begun in the first place, but we are here now, so that no longer matters. Instead, from the current position of the issue, China appears to be in trouble from my view point. News has circulated that China has suddenly reversed their intention on many of the conditions set forth in the talks (IP sharing, purchase agreements, tariff barriers, etc.). The speculation is that China is attempting to stall until the upcoming US election in the hopes that President Trump will lose to a Democratic candidate. However, the US has the upper hand at the moment being the net buyer vs. China as the net seller. Theoretically, the US should be able to sustain the trade war longer than China.

James A. Kostohryz: What "should" happen is a comprehensive trade and investment deal with "rules of the game" that are sustainable and symmetrically beneficial in the long term. What "should" the US do if it cannot negotiate a very good deal? Despite the short-term pain, it would be in the national interest of the US to refuse any deal that is not a "great" deal. It is important to keep in mind that China needs this deal with the US much more than the US needs a deal with China.

Joseph L. Shaefer: Mine is, I'm sure, a minority opinion. In my 'other life', I write and speak on geopolitical issues. China 'should' experience a severe enough economic setback that it becomes willing or forced to be a responsible international trading partner.

Currently, the autocrats running the nation are living the dictum attributed to Lenin: "When the time comes to hang them, the capitalists will line up to sell us the rope." If we study in-country Chinese media, the elites in China see the US and other democracies as their greatest foe. US, UK, Australia et al national security 'should' trump short-term market profits.

Eric Basmajian: What “should” happen is a deal that has little to no substance. Buying more soybeans is a deal that has no substance. What the US needs is something that China cannot provide. Ultimately, the most critical issue is the stealing of intellectual property as a cost of doing business in China. This is a significant advantage for China and something they are unlikely to give up. This makes the probable outcome a deal that has little substance in regards to tackling the core issues that are working to strain the relationship between the US and China.

Robert P. Balan: Mr. Donald Trump and his negotiating team, and China’s trade delegation, are conducting negotiation as they know it best. It’s really a collision of West and East negotiating styles. Western negotiating style strives to tick off the boxes, have a meeting of mind, and once that is done, Western negotiators consider it done. The Eastern style does that too, and more. The process of meeting of minds is just a start. Then, the Eastern negotiators start wearing you out. Now that they have a baseline of what you want, they will systematically undercut your position and bring it down to what they want. And, they lay the onus of saving the deal on you – it is your fault if the deal does not go through. Let’s see if Mr. Trump falls for that. But if he really wants a deal (he needs a deal, sooner or later, otherwise, the deal would have blown up some time ago), then China gets to claw back some of their initial give-aways. Tariffs of 25% were imposed by the US. That is a given - Mr. Trump needs a cover - but the negotiators will agree to keep on talking, and that could support the market (at least for a while). Eventually, the US and China may have a deal, but it may be closer to what the Chinese want; Mr. Trump will not exactly get what he was aiming for, or what he thought he already had.

What do you think is most likely to play out over the coming weeks/months in this trade negotiation arena?

B&B Market: One major factor that I am surprised has not been more pressing is the Belt and Road Initiative. This Chinese initiative plans to create new trade corridors (essentially modern-day Silk roads) from Asia into Europe. Recently, we saw Italy become the first major western power to become involved within this deal, and this may pose a risk long-term for the US when it comes to trade talks. The issue is that there are an incredible amount of complex variables from China's growing military prowess, strides in artificial intelligence, recent success in space programs, etc. I am shocked the BRI has not been more forefront on American news as one of the biggest threats the Chinese have put in place, and I believe it will begin to become a more serious threat with time.

James A. Kostohryz: The most likely outcome of these negotiations: 1) Kicking the can down the road. It is likely that trade negotiation deadlines will be extended continually based on vague reports of "progress." 2) If any deal is actually signed, it is likely that it will be a mediocre deal that leaves too many issues unsolved.

Joseph L. Shaefer: If the administration stays true to its decision to realign trade rather than yield to Wall Street concerns for short-term profits, China will: stop manipulating its currency in order to flood world markets with their products, allow non-Chinese firms the same access that Chinese firms are allowed in the US in sectors like communications, energy and automobiles, cease and desist from stealing intellectual property as well as from forcing foreign firms to divulge proprietary technologies.

If the administration instead folds, the market will rise for a few days in the short term, but US companies will be significantly disadvantaged in all global dealings going forward.

Eric Basmajian: I think the most likely outcome is that a deal gets done, which is in the interest of both parties, but for the substance of the agreement to be light. What the US wants/needs in terms of intellectual property protection is something that China more than likely cannot give. The issues around trade and the trade deficit are not the critical issues at hand.

Robert P. Balan: An eventual agreement will end this first skirmish, but it won’t end the war. The U.S and China could have a mutually beneficial trade relationship and still run a hefty trade imbalance - so long as the U.S. is able to compete with China on a level playing field. But that is not the case, and there is broad agreement in the US political spectrum that this has to end. The U.S. has already found that weaponizing trade and the U.S. Dollar can work against a large exporter into the country, especially adversarial ones. Trump’s government will continue to deploy both trade and the US Dollar as weapons when it serves their purpose. The much-ballyhooed riposte of the Chinese government to sell their outstanding holdings of Treasury bonds in retaliation is shallow and provides no leverage during this, and future, trade skirmishes. The last time, China’s purchases of Treasury bonds actually INCREASED as it sought to devalue the CNY to minimize the impact of the higher tariffs – that was the best means available to them to implement the devaluation. This threat is a toothless tiger for China. FDI inflows collapsed in the wake of recent trade-related devaluation of the CNY. That signifies there is only so much currency weakness that China can engineer as it becomes counter-productive from capital inflows point of view. The US side takes a lot of encouragement from those fails.

Between Q1 earnings, economic reports, and market valuations, there's plenty of other inputs out there for the market. So, side-stepping the trade talk discussion, what do you make of where we are in the market and the economy?

James A. Kostohryz: The US economy is poised for a continuation of the current economic expansion for a prolonged period of time. In this context, the bull market in US equities is likely to proceed and make successive new highs. In accordance with my modeling of US business cycle progression, assuming the absence of a macro-economically significant shock, I expect conditions for US stocks to remain favorable - at minimum - for the next 10-16 months.

Joseph L. Shaefer: I see none of the usual markers and indicators for a market that has become so exuberant that there is no one left to buy. Indeed, this has been a stealth bull, rising steadily in the shadow of a wall of worry.

In the short term, I see the economy continuing to expand and the markets continuing to expect/predict more of the same. Longer term, we will reach that point where the last holdouts have recognized they have missed a great bull market. As they toss their money and their hopes into the ring, the markets will need to exhale. They will do so via a bear correction. When the last few bulls give up and sell or swear off investing in equities, that will mark the beginning of the next bull market.

Eric Basmajian: The economy remains in a trend of deceleration. The economy is not yet at risk of a recession, but those risks are rising. We see continued weakness in cyclical sectors such as housing, durable goods consumption and auto sales which have deteriorated further in Q2. As a result of the deceleration in economic growth, a trend that is unlikely to change over the next few months based on the leading indicators, the expectation should be for lower interest rates and for the odds of a rate cut from the Federal Reserve to continue creeping higher.

Robert P. Balan: The ISM Purchasing Managers survey provides a good approximation of the state of the GDP. But there is a better metric, which not only provides a long lead into the GDP mechanics but also provides a short lead into stock market trends. That is the ISM New Orders less ISM Inventories. It leads the ISM survey index by at least three months and the GDP by almost 2 quarters. This metric has been falling for some time, in fact, since peaking in December 2017. If we allow for the lead, then we can forecast with some certainty that the 4.16% GDP reading on Q2 2018 will be the higher reading we will see until at least September this year. That means the ISM PM Index survey will also be falling until then. The 3.172% GDP reading in Q1 this year is an aberration. Q2 GDP will be significantly lower, and the current read of just above 1.5% by the Atlanta Fed’s GDP Nowcast will not probably improve much in its final level. The modified new orders data is also indicating that the stock market will probably be on a downwards mode until September from here. Exactly as what the PAM liquidity models are saying about the general markets.