Reasons to be cynical about the trade rally

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Financial markets continue to live up to their reputation for getting ahead of themselves. This week’s catalyst was the trade armistice between the US and China, which helped push global equity indices further into record territory. But investors should not dismiss the prospect of renewed skirmishes between the two powers. Nor can they rule out more aggressive posturing from Washington towards other trading partners that run large trade surpluses. Truces can be fragile. The primary consideration for investors is whether the “phase one” deal fosters greater confidence among global businesses and spurs higher levels of investment and economic activity. The current bullish sentiment in the markets mainly reflects how central banks — channelling the mantra “If you build it, he will come”, from the US baseball movie Field of Dreams — have done their job of crushing market volatility through low interest rates, and have laid the ground for an economic rebound. Investors need to see more than just green shoots and bullish analyst forecasts of stronger earnings growth. Faultlines in global trade are still discernible. The White House is not rolling back the full existing tariffs on $360bn of Chinese products until the agreement of a phase two deal. Investors will probably have to wait until after the US elections in November, and probably into next year, before that is sealed. There will also be losers from this preliminary deal should China purchase an additional $200bn of US goods over the next two years as agreed. George Saravelos at Deutsche Bank observes that “China will have to shift existing and future demand for goods towards the US . . . The US trade deficit could improve at the expense of others.’’ German manufacturers and Brazilian farmers, in particular, stand to lose out, he thinks. Meanwhile, the US Treasury will keep up its campaign against potential currency manipulators, with the likes of China, Japan, Korea, Germany, Italy, Ireland, Singapore, Malaysia, Vietnam and Switzerland all sitting on its monitoring list. All in all, “further actions by the US on trade risks harming an already soft outlook for global trade growth in 2020”, said Win Thin at Brown Brothers Harriman.A possible trigger for future trade conflict is that Chinese subsidies and alleged cyber theft were not addressed in this week’s treaty, because they are seen as part of the phase two agreement. The prospect of two separate technology systems in the US and China, as companies decouple their supply chains, remains firmly in play. It puts Europe and many global-orientated companies in a tough spot.For broader market sentiment, one of the most important developments over the past few months has been a steady appreciation in the value of China’s currency. The renminbi has quietly returned to a level last seen in July, and more importantly has appreciated through the Rmb7 per dollar level that caused angst when it was breached last August. A world where the renminbi rallies and the dollar depreciates is good news for emerging markets, as higher local currencies improve returns. Investor enthusiasm for EM is strong. BNY Mellon notes substantial demand for Chinese equities at the moment, as many investors consider valuations on the S&P 500, the major US equity index, as stretched. EM equities have outperformed rivals since October, led by Asia. An MSCI index of global companies reliant upon significant revenues from China has also enjoyed a near 20 per cent bounce since October. Such a performance whets the appetite of investors who anticipate a prolonged rotation from expensive US equities towards emerging markets, which have long been cheap and for good reason. For all their recent strength, EM equities remain a good margin below their 2007 peak. Declining global trade volume has been accompanied by a commodity bust, and a much firmer US dollar in recent years. Many emerging economies have endured slowing growth and a more challenging demographic backdrop, highlighted by China’s birth rate falling to a record low last year. But investors also need to assess the limits to the current EM rally. An easing in trade tensions between the US and China, alongside recent dollar weakness and infusions of liquidity from global central banks, can certainly sustain further gains. But how long that will last depends largely on Beijing and whether it adheres to the demands of the truce. A stronger currency and the retention of US tariffs would be further headwinds for China’s slowing economy. Investors should be alive to signs of the ceasefire breaking down. As TS Lombard analysts highlight, “currency stability and the expansion of bilateral trade are the most important for assessing the deal’s short-term durability since any non-compliance on these will be evident immediately”.michael.mackenzie@ft.com

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