Special Report
Highlights So What? Optimism over a U.S.-China trade deal is becoming excessive. Why? Presidents Trump and Xi appear to want a deal but their late March summit is not yet finalized. Several news reports supporting the bullish consensus are overrated. The odds of a “grand compromise” that entails China implementing U.S. structural demands are 10%. The odds of trade war escalation are 30%. China’s policy stimulus is a better reason than trade talks to become more constructive on Chinese and China-sensitive risk assets. Feature The Chinese equity market is rallying enthusiastically as the annual “Two Sessions” legislative meeting convenes (Chart 1). The basis for the rally is evidence of greater policy support for the economy along with a general belief that the U.S. and China are close to concluding a trade deal, possibly at a fourth summit between President Donald Trump and Xi Jinping that may be held in late March. The NPC session will build on the optimism with Premier Li Keqiang’s promise of more “forceful” policy support and the passage of a new foreign investment law that promises fair treatment to foreign companies. Chart 1Positive Trade Signals, But Market Getting Ahead Of Itself Our view is that the trade signals are broadly positive – implying a 70% chance that tariffs will either remain frozen or decrease in the scenario analysis below – but that the market is getting ahead of itself both in terms of the likelihood of a “structural deal” and in terms of the positive market impact from any deal. The market impact will depend on the depth of the concessions that China offers the United States. If the concessions are significant, President Donald Trump will be able to roll back tariffs to a considerable extent – trade policy uncertainty will fall, China’s economic outlook will improve, and Trump’s reelection odds (and hence U.S. economic policy continuity) could increase marginally. If China’s concessions are slight, tariff rollbacks will be limited or non-existent and the deal will stand on shaky ground, ensuring elevated policy uncertainty in the aftermath of the agreement and raising the probability of a relapse into trade war ahead of the 2020 election. Trump may feel he has to prove his protectionist credentials anew against a trade critic in the general election. Will the outcome be positive enough to surprise Chinese and global markets that have already discounted a lot of positive news? From where we sit, this is unlikely. More likely, investors will be underwhelmed by a lack of resolution or the shallowness of a deal. The risk to this view is the aforementioned structural deal that involves substantial Chinese concessions combined with a major reduction in U.S. tariffs and sanctions. But even in this case investors will face additional trade uncertainty relating to the U.S. Section 232 investigation into auto imports, on which Trump must decide by May 18, underscoring the point that trade alone is not a firm basis for bullish investment recommendations over the course of H1 2019. The continued strength of the U.S. economy and China’s policy stimulus provide a more realistic basis for global risk assets to rally over the 6-12 month horizon. Presidential Momentum For A Trade Deal We remain pessimistic about U.S.-China relations in general and the prospects for a structural trade deal in particular. This is reflected in our subjective trade-deal probabilities, which hold that an additional extension is as likely as a final deal this month and that the risk of a relapse into trade war remains elevated at 30% (Table 1). Table 1Updated Trade War Probabilities Fundamentally, our pessimism stems from our view that the U.S. and China are locked in the early chapters of an epic struggle for supremacy in Asia Pacific that will reduce their ability to engage cooperatively (Chart 2). Chart 2China, U.S. In Geopolitical Power Struggle Critically, the economic impact of a trade war is not prohibitive for either country. China is not as reliant on exports as it once was. In addition, neither the U.S. nor China is too reliant on trade with the other to make a trade war unthinkable, as was the case with Canada and Mexico (Chart 3). Chart 3Economic Impact Of A Trade War Is Not Prohibitive China is economically vulnerable but is politically centralized, as symbolized by Xi Jinping’s aggressive purge of the Communist Party on the basis of corruption (Chart 4). The ruling party can and will accept the worst international economic outcomes since 1989-91, if it believes this is necessary for regime survival. Chart 4Regime Survival is Paramount Meanwhile the U.S. is economically insulated and performing relatively well (Chart 5), and is not politically divided on the question of China. A bipartisan, hawkish consensus has developed that will be discussed below. Just as we argued correctly that this trade war would occur, so too we believe it has a fair chance of reigniting. This could be due to policy miscalculation, unforeseen events, or the likelihood that Trump will face heat from the left-wing ahead of the election if he gives China as easy of a deal as he gave to Canada. Chart 5The U.S. Economy Is Strong But Softening... Nevertheless we accept that there is top-level momentum in favor of a deal for the time being, and this comes from both Presidents Trump and Xi. In China, delaying tactics are the standard way of coping with an angry Washington, as the perception in Beijing is that economic and technological advancement give it greater leverage over time. Moreover, the economy is weakening on several fronts, private sector sentiment is bearish, and the easing of fiscal and monetary policy is of unclear effectiveness (Chart 6). These are all reasons for Xi to seek at least a temporary reprieve. Chart 6...While the Chinese Economy Is Weak But Stimulating In the United States, Trump faces a difficult election campaign due to his relatively low job approval with voters (Chart 7). His polling has recently improved with the settlement of the FY2019 budget and avoidance of a second government shutdown, and this is despite his controversial decision to press forward unilaterally on southern border security. But he will be running for office late in the business cycle and is vulnerable to an equity bear market and recession. This explains why he has shown risk aversion since October on market-relevant issues ranging from NAFTA, Iran, and China. A trade deal with China offers the possibility not only of satisfying a campaign promise (renegotiating the terrible trade deals of the past) but also of a substantial boost to investor sentiment and key parts of the U.S. economy via Chinese cash. Thus it is reasonable to assess that Trump and Xi can satisfy their political preference for a deal in the short run. If Xi does not gratify Trump’s campaign platform as a great deal-maker, he will give impetus to Trump to form a grand protectionist coalition. Such a coalition could eventually succeed in constricting China’s technological development, as exemplified by the U.S.’s campaign against Chinese telecoms equipment maker Huawei. Fundamentally, China still depends on the West for the computer chips that are essential building blocks for its manufacturing sector (Chart 8). However, while this is a reason for Xi to play ball, it is far from clear that Xi will rapidly implement deep structural changes demanded by the United States. Xi has good reason to fear that Trump will continue the tech war on national security grounds despite any trade deal. Plus, either Trump or a Democratic president could take new punitive trade measures after 2020, given the underlying strategic struggle. For these reasons China is likely to slow-walk any structural concessions. We recognize that our 35% probability that trade talks will be extended cannot last forever. Assuming that Trump and Xi confirm the time and place of a fourth summit, the probability of some kind of deal will rise toward 70%. We doubt very much that Trump and Xi will attend such a summit without a high degree of confidence in the outcome, unlike the Trump-Kim summit in Hanoi, which suffered from inadequate preparation. Yet even if the probability of a deal rises to 70%, we still think there would remain a 30% chance of either an unexpected extension or a disastrous breakdown in negotiations – and we are not yet at that 70% mark. Bottom Line: Until a Trump-Xi summit is finalized in the context of continued progress in trade negotiations, we maintain our pessimistic probabilities for the trade negotiations, with a 30% chance of total collapse and a 35% chance of a further extension of talks beyond March. Remain Vigilant On The Trade Talks It is debatable whether momentum in favor of a U.S.-China trade deal has increased over the past two weeks as much as the news flow suggests. First, Trump’s extension of the tariff deadline – which he originally envisioned as a pause for a month “or less” – could just as easily lead to additional extensions rather than a quick resolution. This will be clear if a Trump-Xi summit does not materialize in late March. A logical time for the two to meet would be at the G20 summit in Osaka, Japan on June 28-29, which would prolong the trade policy uncertainty for nearly four months from today. Second, reports suggest that China, like the EU, is demanding that all Trump’s tariffs be removed as part of any trade deal. If true, this demand is more likely to result in a failure to make a deal than a total tariff rollback. The reason is that the U.S. needs to retain the ability to adjust Section 301 tariffs based on China’s actual degree of implementation of any commitments it makes to reduce forced technology transfers, economic espionage, and intellectual property theft. Several of these commitments are enshrined in the new foreign investment law that would pass through China’s legislature over the next two weeks (Table 2), but the U.S. will want to ensure that the law is actually implemented. Table 2New Foreign Investment Law Would Be A Positive For U.S.-China Negotiations If the U.S. rolls back all Section 301 tariffs it will lose a convenient legal standing from which to dial the tariffs back up if necessary. It is more likely that part or all of the 10% tariff on $200 billion worth of goods will be rolled back (our short-term trade deal scenario with 25% odds) than that the entire Section 301 tariffs will be rolled back (our best-case trade deal scenario with a 10% probability). The degree of rollback will be a critical indicator of the durability of any deal, as it will make a material difference for China’s export-manufacturing outlook (Chart 9). Thus far, China’s economy has counterintuitively benefited from the trade war due to tariff front-running. Chart 9The Degree Of Tariff Rollback Matters Third, the disagreements between President Trump and his hawkish lead negotiator, U.S. Trade Representative Robert Lighthizer, are likely overstated in their ability to increase the odds of finalizing a deal. There are two arguments for the view that Trump is losing faith in Lighthizer. The first is that he blames Lighthizer’s tough tactics for the equity market selloff. This may not be valid given that stocks continued to sell off after Trump sided with the trade doves and agreed to a trade truce with Xi Jinping. In December the S&P 500 suffered the worst monthly performance since February 2009 and the worst December performance since 1931. The second argument is more substantial and comes from Trump’s public interchange with Lighthizer over the use and value of memorandums of understanding (MOUs). The interchange was awkward and suggests that tensions exist between Trump and his top negotiator.1 However, the episode may have an important implication. Whatever the reason for the disagreement, Lighthizer gained the assent of two Chinese negotiators – Vice Premier Liu He and U.S. ambassador Cui Tiankai – in his declaration, on camera, that the term MOU would be dropped in preference for the term “trade agreement.” The result is that while the deal is still not going to be a “Free Trade Agreement” that requires legislative ratification, the language of the final document will be if anything more, not less, binding. This episode cannot possibly accelerate a final deal. It is hard to believe that Lighthizer is not secretly happy with the result of his dust-up with the president. It is well known – and frequently complained about by Lighthizer and other Trump administration officials – that China has very active diplomacy and makes many international agreements that are more nominal than real in their results. As a simple example, China typically agrees to a larger value of outbound investment than is ultimately realized (Chart 10). In fact, Lighthizer is at the forefront of the administration’s repeated and explicit aim to pin China down to better implementation and enforcement of any agreement. Indeed, in both of Lighthizer’s reports on the Section 301 investigation that motivate the tariffs, he refers to a well-known September 2015 commitment, between President Xi and former U.S. President Barack Obama, not to conduct cyber-espionage against each other’s countries. Lighthizer shares the view of the broader U.S. political establishment that China only temporarily enforced this commitment and later ramped up its hacking to steal trade secrets.2 Chart 10China Known For Overpromising Fourth, Trump’s failure to conclude a peace and denuclearization deal with North Korean leader Kim Jong Un in Hanoi, Vietnam does not increase the odds of a U.S.-China deal – it is either neutral or negative for U.S.-China talks. Whether intentional or not, the summit reminded the Chinese that Trump’s “art of the deal” requires the willingness to walk away from a bad deal. As mentioned, we view the odds of Trump walking away from a China deal at 30%. But the deeper problem is that Trump expects China’s assistance with North Korea as a condition of the trade deal. Whenever Trump thinks that China is not providing enough assistance, he threatens to walk away from talks with Kim. This occurred in May 2018 and has apparently occurred again. The failure of the summit is a failure of U.S.-China diplomacy in the sense that China could not or would not convince Kim Jong Un to offer more concrete steps toward denuclearization. This reflects negatively on the trade talks if it reflects anything at all. Bottom Line: Aside from the presidential momentum behind a trade deal, none of the recent news reports or leaks form a basis for upgrading the probability of a final agreement in late March. Will It Be A “Structural Deal”? Lighthizer is not isolated in driving a hard bargain with China: he enjoys the support of both parties in the U.S. Congress. At his recent testimony on U.S.-China trade to the House Ways and Means Committee, bipartisanship was a key theme. Democrats as well as Republicans voiced support for Lighthizer as the top negotiator due to his strict stance on China’s trade practices, while Lighthizer himself praised both Trump and Democrats such as House Speaker Nancy Pelosi for being skeptical about China’s trade practices as far back as 2001. The takeaway is that Trump needs deep concessions from China – what the top Democrat on the committee called “a structural deal” – in order to defend any trade deal against domestic critics and skeptical voters on the campaign trail in 2020. In other words, there is unanimity in Congress, as there was in May 2018, that Trump should not sacrifice his leverage for a deal limited to Boeings and soybeans but should instead obtain victories on core disagreements: national security, foreign exchange rates, market access, and intellectual property. The MOUs – now “agreements” – that are reportedly being drafted address these core disagreements. Therefore signs of progress in producing final drafts should be seen as evidence that the odds of a final deal are improving: Forced tech transfers: Raising equity caps for foreign investment in key sectors is a headline way to reduce the leverage that Chinese companies have used to extract technology (Table 3). There are other arbitrary licensing and permitting practices that could also be curtailed. Table 3Foreign Investment Equity Caps Intellectual property: China’s purchases of U.S. intellectual property are conspicuously small, especially when considering that China is not yet an innovation giant in terms of international IP licensing receipts relative to the amount that it pays out.3 If the U.S.’s IP trade balance with China were equivalent to its balance with South Korea, it would result in a $36.7 billion improvement in the U.S. balance (Chart 11). Services: China is a major growing market for U.S. service exports but Washington frequently complains about denial of market access, for instance in financial and legal services. Services exports also underscore the above point about intellectual property (Chart 12). Foreign exchange: The U.S. is asking China not to maintain a more market-oriented currency but rather to promote a stronger currency relative to the dollar, perhaps referring to the yuan’s undervaluation according to purchasing power parity (Chart 13). It is impossible for Trump to accept a deal that does not include some text on the currency since he has hammered the issue of Chinese currency manipulation on the campaign trail and is trying to talk down the greenback. South Korea agreed to a currency annex and Japan is likely to do the same, and that makes it even less feasible for China to get off the hook. Non-tariff barriers: The U.S. has a long roster of complaints about China’s trade practices, including subsidies to state-owned companies, dumping, and inadequate health, environmental, and labor standards. Changing these practices will raise the costs of production in China. Changes to non-tariff barriers can also increase American market access in a way that goes beyond the simultaneous demands for lower tariffs on U.S. imports (Chart 14). Chart 13China Not Off The Hook On Currency Manipulation If China pledges improvements on these issues then it could justify substantial tariff rollback, perhaps the entire 10% tariff on $200 billion. This scenario, the best version of our 25% trade deal scenario, would comprise a positive surprise for markets in the current environment. It still could fall short of a grand bargain justifying a total tariff rollback, unless implementation is swift and decisive, which is highly improbable. A lesser but still market-positive surprise would be an American agreement to reduce pressure on Huawei (comparable to the deal reached in May 2018 on that other besieged Chinese tech company, ZTE). Still less positive outcomes would be a partial reduction in the tariff rate or an American agreement to expand or expedite exemptions to existing tariffs. The last would indicate relatively low expectations about the depth of China’s concessions. Bottom Line: Until the actual details of any Chinese structural concessions and American tariff relief are known, the durability of any U.S.-China trade deal cannot be assessed. This warrants at best cautious optimism regarding the trade talks: the two sides are working on draft texts about the right things. Investors will not be positively surprised by an agreement that does not include structural concessions of the nature above as well as substantial American tariff rollback, which is needed to verify American confidence in China’s commitments. Investment Implications The outcomes that are currently available to investors leave substantial room for prolonged trade policy uncertainty (Chart 15). Any further extension of trade talks means that uncertainty will persist at current levels. A deal that includes limited structural concessions means that uncertainty will ease but remain elevated relative to pre-2018 levels, due to the persistent threat of Section 301 tariffs that the U.S. will wield in order to secure Chinese concessions. A failure of negotiations means a dramatic escalation in uncertainty; this is our 30% risk due to the geopolitical and technological struggle underway. We allot only a 10% chance to a grand bargain that includes deep structural reforms and full tariff rollback. Chart 15Trade Uncertainty Will Persist As a final consideration, investors should be aware that the better the U.S.-China trade deal, the higher the probability that Trump imposes tariffs on auto and auto part imports pursuant to the Section 232 investigation into the impact of these imports on national security, which concluded February 17. The Commerce Department’s recommendations are still unknown but it is not a stretch to imagine that the administration has discovered a national security threat. However, this determination alone does not require Trump to impose tariffs. If he is to impose, he has until May 18 to do so. The full value of U.S. auto and auto parts imports is larger than the value of Chinese imports that currently fall under Trump’s tariffs. It is very unlikely that the U.S. will match this size of tariffs against the EU (Chart 16). Certainly it will not do so if the U.S.-China conflict remains unresolved, since it seems a stretch to believe the equity market can sustain both trade wars at the same time. The Trump administration has already found that the China tariffs without negotiations were disruptive to the U.S. equity market and economy, and the U.S. has told the European Union and Japan that it will not impose tariffs as long as negotiations are underway. To do so would be practically to foreclose the possibility of a trade agreement prior to the 2020 election, at least in the case of the EU. Thus it is only after any U.S.-China deal that the risk of EU impositions rises. We take the view that Japan is likely to conclude an agreement with the Trump administration quickly, possibly even before the China deal but almost certainly shortly afterwards. Trump administration officials will also likely intervene on behalf of South Korea due to the strategic need to stay on the same page regarding North Korea, which itself led to the successful renegotiation of the two countries’ existing trade agreement last year (which included autos but did not explicitly exempt Korea from Section 232 auto tariffs). This leaves the EU, which is quarreling with the U.S. over a range of issues: trade, Iran, Russia, China, Brexit, Syria, etc. Our base case is that the U.S. will not impose sweeping Section 232 tariffs on the EU due to the negative impact this would have on the U.S. auto industry, which is rooted in the electorally critical Midwest; the aforementioned risk to the equity market and economy; and the fact that neither the U.S. public, nor Congress, nor the corporate lobby are supportive of a trade war with Europe. Tariffs would also harm the Trump administration’s broader attempt to galvanize Western countries against the strategic challenge of China, Russia, and Iran. Nevertheless, the risk of such sweeping tariffs is non-trivial because Trump does not face legal constraints in imposing them – he can act unilaterally, just as he did with the early Section 232 tariffs on steel and aluminum, which broadly remain in force. A negative trade shock to the EU at a time of economic weakness may not overwhelm the positive trade impact of a U.S.-China deal in the context of China’s policy stimulus, but it would take the shine off of any risk-on exuberance following a China deal. In the end, China’s risk assets are likely to continue benefiting from domestic policy stimulus plus the 70% likelihood that tariffs will not go up. BCA’s Geopolitical Strategy remains cyclically positive Chinese stocks relative to emerging market stocks over a 12-month horizon given China’s more robust stimulus measures and the above trade view. We are shifting our long China Play Index to a trade as opposed to a portfolio hedge. We are also long copper. We would anticipate that the trend for CNY-USD will be flat to up as long as negotiations proceed in a positive manner. BCA’s China Investment Strategy is tactically positive Chinese stocks relative to the global MSCI benchmark on the same basis, but is awaiting more evidence of a stabilization in the earnings outlook before recommending that investors shift to an outright overweight over the cyclical horizon. Still, our China team placed Chinese stocks on upgrade watch in their February 27 Weekly Report, signaling that the next change in recommended allocation is likely to be higher rather than lower.4 Matt Gertken, Vice President Geopolitical Strategy mattg@bcaresearch.com Footnote 1 News reports had indicated that Lighthizer and his Chinese counterparts were negotiating six MOUs – on forced tech transfer and cyber theft, intellectual property rights, services, currency, agriculture, and non-tariff barriers to trade – in pursuit of the March 1 deadline. When asked about the time horizon of the MOUs at a public press conference with the Chinese trade delegation in the White House, President Trump said that MOUs were not the same as a “final, binding contract” that he wanted as an outcome of the talks. Lighthizer spoke up in defense of MOUs, leading the president to publicly disagree with him. Lighthizer then declared that the term “MOU” would no longer be used and instead the two sides would use the term “trade agreement.” 2 This was the same summit at which Xi Jinping declared in the Rose Garden that China had no intention to militarize the South China Sea – an even more frequently cited example of divergence between China’s official rhetoric and policy actions on matters of strategic consequence. 3 Please see Scott Kennedy, “The Fat Tech Dragon: Benchmarking China’s Innovation Drive,” CSIS, August 2017, available at www.csis.org. 4 Please see China Investment Strategy Weekly Report “Dealing With A (Largely) False Narrative,” dated February 27, 2019, available at cis.bcaresearch.com.
