Geopolitical rally to fade but China cycle to drive markets

Today, I discuss the cross asset outlook in light of recent developments in the US-China trade war, Brexit and the China cycle. This week, interest rates rose, stocks rallied and the US dollar weakened. Clearly, geopolitics largely drove markets this week, but in my view fundamental drivers are also at play. First geopolitics. On Friday night, the US and China as exp ected reached a ‘p hase 1' trade agreement. Trump claims that China agreed to buy USD40-50bn annually of US agricultural goods (this has not been confirmed by China), while the US would refrain from raising tariffs of USD250bn of Chinese imports to 30% from 25%, which was scheduled to take place on Tuesday. The completion of the phase 1 trade agreement might occur over the coming 3-5 weeks.

In my view, the partial trade agreement reduces the risk of an all-out economic war between the US and China. However, I believe the uncertainty will persist for companies closely integrated into global value chains, particularly those with a direct link to US-China trade. This might still weigh on global business confidence and investments. The difficult part of the negotiations remains and trade tensions could escalate again. China wants the US to roll back tariffs and not just refrain from raising tariffs. However, there is still a risk that Trump will raise tariffs in December. M eanwhile, the US wants China to change its industrial policies (Made in China 2025 and subsidies more generally), which is a red line for Beijing. The fact that China will buy more US agricultural goods will help US farmers, but it will not lift the confidence of global companies with other links to the US-China trade war.

On Brexit, optimism emerged when the Irish PM Varadkar on Thursday said that he now sees a ‘p athway to a deal'. On Friday, the European Commission stated that the EU and the UK have agreed to intensify discussions in coming days. Details are scant, but media speculate that UK PM Johnson no longer insists that Northern Ireland would have to leave the EU custom union, while Varadkar might also has softened his stance. Local media report that the UK and the EU are currently negotiating a deal where Northern Ireland could remain politically part of the EU customs union, but one legally administered by the UK. This might ensure that there would be no need for customs checks on the Island of Ireland (but in the Irish Sea), while allowing Northern Ireland to benefit from trade deals struck by the UK with other countries. The unknowns are whether 1) the UK and the EU will be able to reach a solution during the coming weeks, and 2) the DUP and the hard Brexiteers will support the deal. The chances of PM Johnson securing a deal took a hit on Saturday when DUP deputy leader Nigel Dodds said Northern Ireland would have to remain fully part of the UK customs union.

Recently, we have argued that a Brexit extension and a snap election is the most likely outcome. This remains our view. If we are right, Brexit uncertainty will continue to weigh on European business confidence near-term and EUR/GBP should head back towards 0.90. If we are wrong (I would be happy to be wrong here) and the EU and the UK in fact secure a deal by 31 October, it would be a significant positive for the European economy as it would remove a substantial amount of uncertainty for companies and consumers. It would also support a higher EUR/USD and a lower EUR/GBP (down to around 0.84 in my view). Regardless of the outcome, GBP volatility should remain elevated in the coming weeks. However, in my view other factors are at play in driving markets, which often fly under the radar. China's business cy cle appears to be stabilising (see here). This is slightly earlier than we had expected given the escalation of the trade war in August, but likely reflects a combination of infrastructure investments, residential construction and the weakening of the renminbi. China is driving the global manufacturing cycle as I argued here. A Chinese stabilisation now should provide some support for the Eurozone cycle towards the end of the year.

What do the geopolitical developments and the Chinese cycle imply for asset class performance? Since the trade war escalated in early May, US and European core FI have outperformed, whereas US high yield, DM equities and in particular EM equities have underperformed. However, the trend changed in early September, likely related to news that the US and China had agreed to trade talks in October, better China data, and the ECB's inability or unwillingness to act more forcefully at its meeting on 12 September. In my view, the euphoria in markets over a US-China trade deal and a Brexit breakthrough last week are likely to fade in the coming week. This should drive a weaker GBP while last week's sell-off in USD versus Scandi currencies should fade, see here. However, we are unlikely to go back to the horror in August, when markets faced significant risks of an all-out economic war between the US and China and a hard Brexit. In addition, China is stabilising. These factors could support a gradually better performance of equities relative to core FI. On tomorrow's M acro Strategy View podcast, our UK economist Mikael Olai Milhøj and I will discuss the crunch time in the Brexit negotiations. Stay tuned. That is all for today.

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