Presidents Xi and Trump
It's now confirmed that Presidents Trump and Xi are set to meet at the G20 later this week. And while US administration officials have said we shouldn't expect a deal but rather a path forward for negotiations, this is still welcome news to anyone looking for relief from the tit-for-tat tariff escalation between the US and China. Communication may not be sufficient to break the escalatory cycle, but it's a necessary condition. And it's timely, too, as the US authorization to levy tariffs on a further ~US$300 billion of imports from China takes effect in early July. So as we enter this week, there seems good reason to expect that the G20 will result in a tariff 'pause', affording both sides a defined period of time to get negotiations back on track before resorting to further tariff escalation.

But investors beware: while a pause is better than escalation, it won't refresh the economy enough to forestall a challenging path for risk assets. A pause, particularly one that comes without preconditions and follows a period of heated rhetoric, would be positive, signaling that both sides want to avoid further economic damage. If it coincides with Fed dovishness, a pause could boost investor sentiment and risk asset prices in the short term. However, we'd view this more as a set-up to sell risk than a catalyst to turn more bullish. Consider the following:

  1. Market or economic weakness might be needed to avoid further tariffs and make the pause permanent: Just because the US and China may agree to put more negotiating time on the clock doesn't mean they've made any progress on the points that divide them: codifying IP protections, when to remove existing tariffs, and how much to reduce the trade deficit via asset purchases. These gaps will be difficult to bridge, in our view. As we've argued previously in the Sunday Start, we think that game theory is a useful framework to gauge how this could play out. These differences are incentives for each side to escalate. We expect that market or economic weakness would clarify the benefits of de-escalation and lead to a deal, but this may not give investors much comfort.
  2. A pause doesn't fix the ongoing pressure from the 'downside of fiscal stimulus': Tariffs are not the sole policy challenge to markets, but rather an accelerant of the risks created by a US policy choice made in 2017: to apply fiscal stimulus through tax cuts when the economy was already in good shape. Back then, we posed this question: though tax reform could prove beneficial over the long term, what did US$1.5 trillion of tax cuts do for the current economic cycle? To us, it's been more 'happy hour in America' than 'morning in America'. Stimulus in good economic times generally has a lower multiplier effect, and expiring provisions in the tax cuts are already pushing effective corporate tax rates higher and creating pro-cyclical incentives. Not surprisingly, our latest Morgan Stanley Business Conditions Index registered a precipitous drop, reflecting declines in hiring, hiring plans, and capital spending plans among US companies. Said more simply, the best impacts of the tax cuts to economic growth and corporate profitability were short-lived, are now likely behind us, and may be putting pressure on profit margins and the economic cycle. Avoiding further tariffs won't change this dynamic.
  3. Tariffs have already impacted the global economy: PMIs had been moving lower since the beginning of 2018, driven mainly by trade tensions. The latest deterioration in manufacturing PMIs reflects a further hit to corporate confidence, with the declines most pronounced in the US, China and Korea. Trade tensions were frequently cited as a concern.
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Taken together, we think that the benefits of a pause lie mainly in its ability to delay, but not resolve, downside risks to economic fundamentals. Hence, a pause would reinforce our current views: a range-bound path for the S&P, with a downward skew from current levels; a wider bias for credit spreads; and a preference for government bonds on our economists' expectation for further Fed easing.