Risk temperature at boiling point

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As talks over trade between the US and China begin in Washington, the temperature has risen to a critical level. China’s message of retaliating with “necessary countermeasures” should the US raise tariffs on Friday, has duly heightened anxiety among traders and investors.

A more alarming market reaction to date has only been prevented by the binary outcome of either bad news or some light at the end of the tunnel dawning on Friday. In other words, risk aversion either boils over or starts cooling off.

Equities and sectors exposed to global trade (US technology, materials and industrials along with eurozone carmakers and miners) have certainly suffered this week, but the scale of the selling has been restrained by the risk of a positive development that cools the temperature and sparks a classic “relief” trade. There was a taste of this on Thursday as Wall Street bounced from its lows as Mr Trump spoke at the White House and said a deal was still possible, while adding: “I have no idea what’s going to happen. We’re going to find out about China tonight.”

Currencies are usually in the vanguard of big market shifts and it’s worth keeping an eye on China’s renminbi and the Japanese yen in particular. China’s onshore currency on Thursday weakened to Rmb6.8071, its lowest level against the US dollar since January.

Last year when trade tension was notably driving the anxiety factor, the Rmb headed towards the 7 area, long seen as a line in the sand for markets. Not since 2008 has the currency been that weak versus the US dollar and holding this level has been seen as desirable in terms of preventing capital flight from China and sparking a damaging wave of currency devaluations that would ripple across emerging markets.

Understandably, concern within foreign exchange circles is building that higher US tariffs will propel the Rmb towards that marker and beyond. If we see that, things will get very messy in the markets. 

The concern over the Rmb’s near-term direction is illustrated by a stunning rise in implied volatility alongside a surge in demand for hedging against the risk of a much weaker currency. 

Mandy Xu at Credit Suisse points out that currency volatility for the Rmb versus the US dollar was trading at its lowest in a year last week, only to “have since surged to a near 1-year high”.

Another eye-catching shift has taken place in one-month currency risk reversals, an area that until the recent six month delay over Brexit was dominated by the UK pound. In very short time, the demand for options that become profitable from a much weaker Rmb over the next month in both the onshore and offshore markets has risen above their respective 2018 peaks. The offshore risk reversal shown below loiters near its February 2018 peak of 1.43 after US tariffs on Chinese-made solar panels and washing machines were introduced. At a current level of 1.375, a test of the 2016 peak above 4 remains well out of bounds at this stage.

This is one market to definitely watch over the coming hours and Mandy highlights the scale of uncertainty facing the market:

“While we think risk is still tilted to the downside ahead of tomorrow’s tariff deadline, the situation is fast moving and we could be one tweet away from a major reversal.”

Hardly reassuring is the point raised by Deutsche Bank’s George Saravelos that shifts between the USD and Rmb “have been fairly consistently in line with the weighted average tariffs imposed by the US on Chinese imports”.

As the bank shows via this table: “The new 25% tariff on $200bn of goods will bring average tariffs to 12% — commensurate with USD/CNH above 7 to offset the impact.”

In turn, DB also highlight how the Rmb is among the most expensive currencies in their view, while the Japanese yen sits at the other end of the spectrum as shown here:

So one likely reaction from a trade impasse and the imposition of higher tariffs would involve selling the Rmb versus the yen. The fallout would also extend to China growth proxies, the Australian dollar and the Korean won, two currencies that this week have touched multiyear lows and sit on the expensive side of the DB valuation wheel.

In terms of protecting investment portfolios from the gathering storm between the US and China over trade, holding exposure to the yen is a popular call. 

As UBS write:

“The undervaluation of the Japanese yen, along with its tendency to appreciate when global risk aversion increases, makes the yen an attractive countercyclical position.”

And from Market Forces yesterday, that extends to owning top-tier government bonds, which leaves Italy off the list. The 10-year BTP yield is 7 basis points higher on Thursday, while the 10-year German Bund sits at minus 0.05 per cent. In the US, the 10-year Treasury yield briefly dropped below that of the three-month T-bill, the first inversion since March and another sign of fragile sentiment. 

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Quick Hits — What’s on the markets radar

One sliver of light on trade — Here’s an interesting line from the FT’s coverage of the trade showdown and one that may provide some breathing room for markets. Higher US tariffs would apply to products exported from China starting on Friday and not goods that are already in transit. As the FT writes

“The clarification offers US and Chinese negotiators a window of two to four weeks to reach a deal before the bulk of the pain from the higher tariffs hits US consumers and businesses, based on shipping times between the countries.”

Investors debate who holds the trade war cards — President Trump, some argue, can push for higher tariffs with the ensuing hit to markets and the US economy offset by the likelihood of the Federal Reserve and other central banks cutting rates. The argument favouring China playing a longer game from here is that they can wait until the 2020 US presidential election for starters, while they have already begun the process of diversifying away from the US towards other trading partners.

A popular view remains that for all the political posturing, it serves the interests of both the US and China not to prompt a major bout of market turmoil that in turn weighs on broader economic activity. Others take comfort that so long as the US and China keep talking, irrespective of tariffs rising on Friday, the path is open towards an eventual agreement.

Analysts at Citi sum up the consensus thinking: 

“Trump’s renewed tariff threat is likely being used as part of a strategy to cement concessions from China. Citi’s base case remains for a trade deal in 2Q.”

That raises the question of just what kind of agreement is feasible and more importantly will it stand up over time. Mr Trump and US trade hawks have plenty of company and heading into the 2020 election cycle, getting tough with China is a vote winner. The president’s approval rating via Gallup has climbed to its highest level for his presidency at 46 per cent. And beyond China, the US has yet to apply the pressure on Germany and the eurozone.

The fallout from higher US tariffs beyond China — Société Générale believes the pain will resonate in Taiwan and Korea, while India looks a better place to build equity exposure.

“According to our economists, 17% and 14% of this tranche of China exports ($267bn) consist of mobile phones and laptops respectively. And Taiwan and Korea are among the two countries with the highest value-added contribution to Chinese exports to the US (respectively 2.2% and 1.3% of GDP). In that environment, India equities would be the Asia outperformer.”

US small-caps are no port in the storm — The two main US benchmarks for smaller listed companies, the S&P 600 and Russell 2000 both sit 10 per cent below their record peaks of late August 2018, but they have slightly outperformed the S&P 500 so far this year. One view is that small-caps are insulated from global headwinds due to their domestic focus. But broad market stress that results in wider credit spreads or higher borrowing costs matters for small-caps and as DataTrek point out:

“The spreads for BB-or-worse US corporate debt over Treasuries are currently 3.89 percentage points. That is higher than any point in 2018, even if it is lower than late December 2018’s +5.00 percentage points.”

Buying small-caps as a defensive strategy in the event that larger more globally orientated larger US companies suffer from escalating trade tension runs the risk of backfiring as greater macro stress likely results in wider credit spreads. 

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I’d love to hear from you. You can email me on michael.mackenzie@ft.com and follow me on Twitter at @michaellachlan.

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