Institute Alert

Wells Fargo Investment Institute strategists provide insights on this week’s market volatility and guidance for what may be ahead.

May 28, 2019

Paul Christopher, CFA, Head of Global Market Strategy

Darrell L. Cronk, CFA, President of Wells Fargo Investment Institute

He Said, Xi Said: Can There Be a U.S.-China Trade Deal?

Key takeaways

  • Since early May, public statements by U.S. and Chinese leaders have seemed to undercut their assurance of progress from earlier in the year.
  • Our long-standing view is that a U.S.-China trade deal is likely, but recent events introduce ambiguity about how soon and how comprehensive a deal may be.

What it may mean for investors

  • We favor keeping portfolios close to neutral (i.e., at long-term target allocations). This neutral approach to allocation recognizes that fundamental economic growth and inflation support financial markets, but political uncertainties will remain a reason to be more proactive with portfolios.

Download the report (PDF)

There is no good time for the U.S. and China to escalate their trade conflict. Unfortunately, the negotiating landscape now shows greater differences than markets previously anticipated.

1. What are the likely core components needed for a deal?

The U.S. and China have talked publicly about compromises. China offered to buy more U.S. grain and energy, and to limit policies that undervalue its currency. The U.S. might remove some of its new tariffs. However, in early May, China said it would renegotiate these easier issues as part of the talks over the more complex issues, and this triggered the latest tariff escalation.

There are three more complex issues:

  • The U.S. wants Chinese laws to protect intellectual property and patents. China prefers regulations to enforce these provisions, which the U.S. considers to be unacceptable.
  • China argues that last year’s tariffs should be removed, now that negotiations are in progress. The U.S. wants to keep the tariffs to enforce China’s compliance.
  • China’s industrial policies are another big obstacle. China subsidizes industries that it wants to become global leaders, especially in biotechnology and telecommunications—and the Belt and Road Initiative would expand China’s economic partnerships throughout Europe and Asia. These policies directly challenge U.S. global economic leadership. Washington’s allegation of espionage against a Chinese telecom firm only heightens U.S. concerns.

2. What outcomes may investors anticipate?

A U.S.-China trade deal is very difficult to predict and could come any time. We see three possible outcomes, but we believe that extended negotiations are most likely:

  • A relatively quick deal: The two presidents are slated to meet in Osaka, Japan for a multilateral summit on June 28 and 29. Considering the recent backtracking, a deal by July seems unlikely.
  • No deal: A complete breakdown in the talks may reset expectations for higher (and permanent) tariffs. It is also the worst case for the respective presidents. Tariffs are deliberate self-injury, and each side has only limited additional stimulus available to counter a potentially deteriorating economic outlook. We consider this the least likely scenario.
  • A deal is achieved, but only after more brinksmanship and negotiation: The limited impact of the tariffs so far increases the probability of brinkmanship and longer negotiations. To date, the direct tariff impact has been small on household and business spending when spread across the U.S., China, and much of Asia. There are potentially larger indirect effects as firms reroute their supply chains, but these are building only gradually while businesses use temporary countermeasures to manage what they have assumed to be temporary tariffs.

    The leaders seem to want a “longer game,” but the economic damage accumulates while the tariffs remain. The Chinese may want to see if President Trump loses his reelection bid. The White House may want a deal close enough to Election Day 2020 that voters remember the tough U.S. line and (hopefully) favorable deal. Yet, the larger and broader the tariffs, and the longer they continue, the greater the direct and indirect economic losses are likely to be on both sides. This political and economic balancing act should produce a deal later in 2019 or early in 2020.

3. What is the likely sector impact?

The U.S. equity sector impacts still appear to be limited, but they should increase the longer the brinksmanship continues—and if the scope of a deal narrows. Consumer Discretionary, Industrials, and Information Technology seem to be the most negatively affected sectors. Until now, the consensus for the past 12 months has been that a quick deal would not require costly supply chain adjustments. Now, it appears that investment is being delayed (in semiconductors, for example); resourcing supply chains may incur costs in the coming 2-3 quarters (for Consumer Discretionary); and some technology firms are lowering guidance.

4. What are the nontariff options that could come from the negotiations?

Each country has some nontariff leverage over the other, but not all measures are equally likely:

  • Regulatory measures: China could increase regulation of U.S. companies in China, and accuse more U.S. firms under China’s punitive anti-monopoly law. The U.S. could limit Chinese investment in the United States. Both countries could impose more onerous visa and customs rules.
  • Espionage: Chinese government-affiliated persons could hack U.S. users.
  • Diplomatic pressure: China could expand its military outposts on reefs and cays in the East and South China Seas, or buy more Iranian oil to frustrate the U.S. administration over its Iranian sanctions. China can influence North Korea to delay its denuclearization, while the U.S. could sell more arms to Taiwan.
  • China could sell a large portion of its U.S. Treasury securities: This is unlikely in our view. Selling a large portion of China’s Treasury securities probably would lower prices, thereby devaluing China’s remaining portfolio and forcing unwanted appreciation in the Chinese currency. China also could force itself into the unattractive choice of seeking larger shares of issues in smaller global sovereign bond markets that have lower yields.

Conclusions

Recent surprises in the U.S.-China trade negotiations mark additional uncertainty and change. Below, we outline our conclusions today—and what we anticipate from the future course of the negotiations:

  • For the first time, the two sides are willing to impose punitive measures during negotiations. This new escalation threat raises economic risks.
  • We still expect a U.S.-China trade deal later this year or in 2020, but the two sides could be settling in for a longer negotiation, with more open brinksmanship.
  • We believe that global equity markets are overestimating the chance of a deal in Osaka. Consequently, we believe that the risk of a longer standoff appears to be larger than markets have “priced in.”

Our strategy is to look for opportunities to rebalance portfolios when markets move significantly in either direction. On pullbacks, we will look for opportunities to allocate cash in global equities. But if markets rise steadily, we expect to take a more neutral position and, where appropriate, trim positions toward long-term target allocations. This is rebalancing, and it is a way to maintain those allocations, which we believe are the foundation for the investor’s long-term plan.

Risk Considerations

Each asset class has its own risk and return characteristics. The level of risk associated with a particular investment or asset class generally correlates with the level of return the investment or asset class might achieve. Stock markets, especially foreign markets, are volatile. Stock values may fluctuate in response to general economic and market conditions, the prospects of individual companies, and industry sectors. Foreign investing has additional risks including those associated with currency fluctuation, political and economic instability, and different accounting standards. These risks are heightened in emerging markets.

Global Investment Strategy (GIS) is a division of Wells Fargo Investment Institute, Inc. (WFII). WFII is a registered investment adviser and wholly owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.

The information in this report was prepared by Global Investment Strategy. Opinions represent GIS’ opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. GIS does not undertake to advise you of any change in its opinions or the information contained in this report. Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon.

Wells Fargo Advisors is registered with the U.S. Securities and Exchange Commission and the Financial Industry Regulatory Authority, but is not licensed or registered with any financial services regulatory authority outside of the U.S. Non-U.S. residents who maintain U.S.-based financial services account(s) with Wells Fargo Advisors may not be afforded certain protections conferred by legislation and regulations in their country of residence in respect of any investments, investment transactions or communications made with Wells Fargo Advisors.

Wells Fargo Advisors is a trade name used by Wells Fargo Clearing Services, LLC and Wells Fargo Advisors Financial Network, LLC, Members SIPC, separate registered broker-dealers and non-bank affiliates of Wells Fargo & Company.