The impact of the US/China trade talks in equities and currencies

The trade dispute between the United States and China, assumed until Sunday to be on its way to a negotiated resolution, blew up into a major market event when US President Donald Trump threatened to increase tariffs on many Chinese imports to 25%.

Mr. Trump accused the Chinese of reneging on the commitment to change their laws to accommodate the terms of the draft agreement.  

China stalled for two days. Vice-premier Liu He had been scheduled to head a large delegation to Washington on Wednesday for completing a draft agreement. Then Beijing decided to send Mr. Liu with a smaller team to continue the talks on Thursday.

According to Reuters and its US sources China systematically edited the 150-page draft trade agreement reversing the key US demand that China commit to changing its laws to enforce the treaty.

Mr. Trump declined to break off talks and Mr. Lui will arrive presumably with something to discuss, knowing the administration’s displeasure.  On Wednesday the President announced in a tweet that China’s trade representative is “coming to the US to make a deal.”

While the conclusion of the yearlong trade wrangle is still undecided the reactions of the equity and currency markets were quite different. Equities dropped sharply on Monday, recovered, were slammed on Tuesday and mostly flat on Wednesday on some encouraging if not concrete news from the Washington.  

Currencies on the other hand seemed almost unaware there was a Chinese trade delegation in Washington for talks that will move the global economy whatever their denouement.

The Dow closed Friday at 26,504, opened on Monday down 344 points at 26,160 sank another 127 to 26,033 and then closed at 26,438, 66 points lower than the weekend close.  Tuesday was a straight loss of 473 points from Monday’s finish at 25,965. Wednesday showed a minor gain of about 20 points in the early afternoon.  

Reuters

The S&P 500 ended Monday down 13 points from the Friday close at 2932,  lost 48 points to 2884 on Tuesday and was essentially flat on Wednesday.

Currencies showed little reaction to the trade talk developments.

The euro closed on Friday at 1.1200. On Wednesday afternoon it was trading at 1.1187 having traversed a 63 point range, 1.1158-1.1221 in the interim.

Sterling volatility closing at 1.3171 on Friday and dropping to 1.3006  Wednesday afternoon was largely  Brexit related as Prime Minister May struggles to survive and find a coherent program for the UK’s relationship with Europe.

The Australian Dollar closed Friday at 0.7023 and despite Tuesday’s run to 0.7048 on the RBA’s rate hold, it was no more than 30 points lower on Wednesday at 0.6995.  Its antipodean colleague the New Zealand Dollar managed only a 70 point range Friday to Wednesday despite the central bank rate cut. Even Dollar Canada a major resource economy deeply affected by growth prospects in China, moved less than 50 points Friday close to Wednesday afternoon, 1.3420 to 1.3463. Its range 1.3406-93.

The one exception, if you can call it that, has been the Japanese Yen. It lost almost a figure to Wednesday, 111.09 to 110.13.

The equity link to the China trade talks is straightforward and two-fold. Many large and mid-sized US firms manufacture or assemble in China. Many others distribute and sell these products in the United States. Tariffs will directly hit their sales and bottom line.

Secondly, a prolonged trade spat between the world’s two largest economies, with the US and China imposing competing and escalating duties can only drive weak global growth down. With the IMF currently estimating 2019 at 3.3%, down from 3.7% in October, an acrimonious trade war will have global repercussions and a potential recession.

For equities the fallout from the trade talks is binary, an agreement is good, a trade war is not.

For currencies the impact is not so straight forward.  For example the US Dollar. A trade war will subtract from GDP, it will damage a large swath of US firms and will extract a charge from equity value, all negative for the US economy and presumably the dollar.  

Yet the economic impact is relative because it is measured through the dollar, that is against the economies of its competitors.  The US expanded 3.2% in the first quarter far ahead of Europe and Japan. The Federal Reserve, with its main interest rate at 2.5% is much better positioned to support the economy should it become necessary, than the ECB or the Bank of Japan. The US economy, with its vast internal market is also less dependent on exports than any other major industrial power.

There is also a countervailing feature to currency markets, the safe-haven trade.  

When there is turmoil in the global economy currency traders and investors turn to the US Dollar and the American economy.  The outstanding example was the ascent of the dollar in the financial crisis of a decade ago.  The Japanese Yen also fills this role, if to a lesser degree, particularly when the source of the unease is in Asia.

A prolonged trade war with China would play havoc with the demand for resources and with the currencies of the commodity complex. Countries that are able to provide substitutes to China for American agriculture products would benefit but in general demand will drop for commodities from iron ore to oil and soybeans and everything in between.

The long term effects of a trade confrontation between the US and China are more varied in the currencies than in the equity markets, where the impact is almost universally negative.

Even though the initial move in currencies, were the trade talks to break down, would be to the dollar there are many other possibilities as the ramifications of the confrontation work their way through the global economy.  

In currencies there is as much potential for profit as for loss from any event. Traders are waiting for the final curtain before they move.