Adding to equities after US-China agreement

The US and China have announced that they have struck a deal on trade.

The US has announced it will roll back the tariff rate on USD 120bn of Chinese goods from 15% to 7.5% and will not be adding tariffs to USD 160bn of Chinese goods, a move which had been scheduled to go into effect on 15 December. A 25% tariff rate will remain in place on approximately USD 250bn of Chinese goods. In return, China has agreed to increase its purchases of US goods and services, particularly agricultural products.

We think it is significant that the announcement represents the first time that trade negotiations have successfully led to an actual reduction in tariffs, rather than a mere delay.

We may have reached the point of “peak tariffs” and this deal could represent the start of a series of phased rollbacks, which could unlock further upside for equity markets, driven by an improvement in business confidence and a recovery in investment. Attractive valuations for stocks relative to high grade bonds should lead to outperformance over a six- to 12-month investment horizon.

In our Year Ahead report we said that, in a Year of Choices, political decisions would drive outcomes. Now, with signs of reconciliation between the US and China reducing downside risks to the global manufacturing sector and consumer sentiment, we respond by adding risk to our portfolios.

We are increasing our risk exposure in our global tactical asset allocation, adding an overweight in emerging market equities and closing our FX strategy's underweight in the Australian dollar versus the US dollar.

We also continue to take risk through carry strategies, which should stand to benefit from improved risk sentiment as well as a prolonged period of low central bank policy rates. Specifically we overweight emerging market hard currency sovereign bonds, and overweight the Indian rupee and Indonesian rupiah in our FX strategy.

Within equity portfolios, along with our new overweight position in emerging market equities, we have a preference for the US and Chinese equity markets. We maintain our preference for US equities versus the Eurozone. While the Eurozone could benefit from a bounce in cyclical markets, increased purchases of US goods by China could come at the expense of other exporters. We also prefer stocks in Japan versus the Eurozone, as the former has priced in less of an economic recovery.

Despite the trade agreement, 2020 will remain a year where political decisions significantly impact markets.

Despite the trade agreement, 2020 will remain a year where political decisions significantly impact markets. In the near term, volatility could be heightened as the specific details of what is and is not included in the deal become known. We note that markets have already rallied in recent weeks – the MSCI All Country World is up 8% since early October, and the scale of the tariff rollback is limited at this stage.

What are we looking out for next?

It is encouraging that China has made commitments on intellectual property and forced technology transfer. We will be looking for detail on the extent of these commitments and how they are likely to be enforced. Tough issues remain, like opening up Chinese markets, but reaching an initial agreement on IP and technology transfer represents greater progress than we expected.

Increased agricultural purchases have been a key focus for the US administration. According to US officials, China has agreed to increase its purchases of agricultural goods from a 2017 baseline of USD 24bn by an additional USD 16bn a year for the next two years and will work towards increasing this USD 40bn total to USD 50bn. In total, the US has said that China has committed to buying USD 200bn of US exports in four sectors: agriculture, manufacturing, energy and services, although Chinese officials have yet to confirm the specific numbers. This part of the agreement will play well with the Trump administration and we will be looking to see whether the president “declares victory” on trade as the election campaign gets underway, which would likely reduce the chances of near-term re-escalation. Uncertainty around trade has also been reduced with the passing of the US, Mexico, Canada trade deal.

The cancellation of the December tariffs reduces the risk of an adverse effect on US consumer confidence.

The cancellation of the December tariffs reduces the risk of an adverse effect on US consumer confidence. The partial roll-back raises the prospect that the deal might be the beginning of a series of tariff reductions, broadening the economic benefit and potentially driving a meaningful improvement in business confidence and investment, which has borne the brunt of the trade dispute. At the least, in our view, we are now likely to see an uptick in replacement investment spending.

The gap between business sentiment and the hard data is currently very wide, providing scope for a narrowing of the difference through a greater rebound in sentiment, which is often a significant factor in near-term market momentum. Global manufacturing PMIs have been increasing since the summer and the trade deal should help that momentum continue. Consequently, the growth outlook for 2020 is marginally better than we initially expected and there’s a greater possibility of upside surprises in GDP growth and corporate earnings. Policy, meanwhile, is likely to remain supportive, even if an improvement in manufacturing helps lift economic growth back towards trend.

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