Why The U.S.-China Deal May Fall Short

Why The U.S.-China Deal May Fall Short

Trade talks between the U.S. and China are set to resume this week with high-level negotiators taking part. However, Cesar Rojas, a global economist at Citigroup, assigns a scant 5% probability to a "comprehensive" deal that's bullish for the U.S. economy and stocks alike. "The U.S. and China are still not ready for a deal," he told CNBC. The table below summarizes Citigroup's three scenarios for a trade deal, indicating overwhelming odds that any trade deal could fall short of investors' most optimistic expectations.

3 China Trade Deal Scenarios

  • Bull Case (5% odds): "comprehensive" deal with tariff rollback as China opens markets to U.S. and pledges to protect U.S. intellectual property
  • Base Case (45% odds): "veneer" of a deal with tariffs held steady and China making fewer commitments on the trade deficit and intellectual property
  • Bear Case (40% odds): no agreement by March 2 deadline, both sides hike tariffs, China hampers U.S. investment and operations of U.S. firms there

Source: Citigroup, as reported by CNBC

Significance For Investors

Bull Case. CItigroup's most optimistic case involves tariffs being rolled back by both countries. China would commit to importing more U.S. manufactured and agricultural products, opening up its markets to more U.S. investment, and taking firm measures to prevent the theft of U.S. intellectual property.

Citigroup believes that a "comprehensive" deal would be especially positive for cyclical stocks, and that global equity markets might enjoy a boost of about 10% in 2019. Rojas adds that commodities such as soybeans, grains, copper and oil should see price gains. "Higher U.S. soybean prices would likely trigger a knock-on rally to corn prices and carry-through to improved farmer moods and spending," which also would boost sales in the U.S. by farm equipment manufacturers, according to Timothy Thein, a Citi analyst quoted by CNBC.

However, as noted above, Citigroup assigns a small 5% probability to its bull case. Among other things, President Trump has stated that a deal would not be announced until he had met again with Chinese President Xi, and this is highly unlikely to happen before March 2.

Base Case. This scenario would postpone the escalation of tariffs. This deal would be based on pledges by China to cut the annual trade imbalance with the U.S. by up to $200 billion by 2020, to enforce U.S. intellectual property rights, and to go more slowly on its Made in China 2025 plan that would tilt Chinese manufacturing towards producing higher-end goods. These would be positives, "but the ongoing verification process and additional restrictions may leave some doubts," Rojas said.

Citi sees the base case as giving a 5% boost to global equities in 2019. It would be a moderate positive for the prices of some metals and agricultural products, notably soybeans. Transportation companies should benefit, partly since additional tariffs on consumer goods would be avoided.

Bear Case. This worst-case outcome applies if the March 2 deadline passes with no deal and President Trump carries through with his promise to hike tariffs on $200 billion of Chinese goods from 10% to 25%. If so, China may retaliate with its own tariff hikes on about $60 billion of U.S.-made goods, as well as placing restrictions on U.S. investment in China, and adding regulatory burdens on U.S. companies. Global equities would fall by about 10% to 15%, Citi estimates.

Even if a deal is reached by the deadline, some uncertainties may remain. John Bilton, head of global multi-asset strategy at JPMorgan Asset Management, believes that all the complexities surrounding issues such as intellectual property and cybersecurity are unlikely to be fully resolved by then. "This could rumble on for a while," he told CNBC.

It's also unclear whether a deal that reduces the U.S. trade deficit will actually benefit U.S. stocks. Citing history since 1970, Jim Paulsen, chief investment strategist at The Leuthold Group, told CNBC, "U.S. stocks have outperformed foreign stocks when our trade deficit worsens, historically...but when our trade deficit improves, international stocks outperform the U.S."

Indeed, a deal would be sell trigger for stocks, according to Shawn Matthews, CEO of hedge fund Hondius Capital Management. "Right now, it's a risk-on mentality--you want to be long riskier assets until you get a deal with China," he told Bloomberg, "You want to fade the rally into the deal--and that deal is probably going to be a watered down deal anyway," he added.

Looking Ahead

Any deal that opens markets in China for U.S. exports, protects U.S. intellectual property, and stabilizes or rolls back tariffs should be positives for U.S. companies and consumers. However, as Jim Paulsen points out, reducing the U.S. trade deficit may not in itself be a positive for U.S. stocks. "When we have a trade deficit it means the U.S. [economy] is doing better," with domestic demand stronger than foreign demand, as he told MarketWatch.

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