Shouting across the trade divide

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Global equities and risky assets have begun the week under the cosh. China’s renminbi weakening to a level previously notched in December set the ball rolling and global stocks have suffered their worst one-day slide for the year. The soothing mood music on Friday about China and the US still talking has now been drowned out by tougher rhetoric from both sides of the trade divide.

China has announced tariffs on $60bn of US goods from June 1, while the US appears set to counter with tariffs on an additional $300bn of exports that take effect within one month. President Donald Trump began the week via his bully pulpit of Twitter by warning Beijing not to retaliate against the US rise in tariffs and added China would be “hurt very badly” if it does not agree to a trade deal “because companies will be forced to leave China for other countries”.

Sitting back and thinking this will all end well remains the consensus view of many in the market and among readers, judging by recent feedback. While I hope this is the case, the makings of a nasty market tantrum are growing, as the White House trade hawks fly and Beijing digs in its heels. 

John Hardy at Saxo Bank says the question “is whether the market remains overconfident that we can avoid an ugly mis-step or worse in the interim. The stakes are high for global investors and the market is rather poorly positioned after ‘stockpiling complacency’ in the wake of the Fed’s dovish policy pivot since the beginning of the year.”

Chatter that the G20 meeting in Japan at the end of June may see Mr Trump meet with Xi Jinping, China’s president, in order to salvage a deal illustrates how the timeline for a treaty is extending, hardly a good outcome. Until recently, the G20 gathering was seen marking a possible venue for signing a trade deal.

The impasse between the US and China highlights another crucial divide within financial markets — that between the noise generated by short-term trading strategies versus the patient approach of long-term investors.

Traders see the duelling political headlines and grab an opportunity to push markets around. Leading the way is a weakening renminbi, which triggers selling more broadly across emerging and developed world equities, currencies and commodities. This has room to run as we are indeed seeing on Monday, and Quick Hits looks at the rising risk aversion towards the Rmb.

In contrast, long-term investors think they can spend the summer waiting for an agreement to arrive that keeps the global economy on track and ultimately bolsters markets. But some of the short-term noise echoing at the moment also reflects the ranks of long-term investors hedging their exposure to a tail risk event such as no deal. This takes the form of buying top-tier government bonds (Monday finds the two-year Treasury below 2.20 per cent with the market rightfully downplaying the threat of China dumping US government paper) seeking the Japanese yen, and put options on equities.

The prospect of a 25 basis point Federal Reserve rate cut by the end of the year is now priced in with the January 2020 Fed funds contract implying a rate of 2.07 per cent versus the current effective rate of 2.38 per cent. 

At this stage, it is worth noting that the S&P 500 has only fallen less than 5 per cent from its recent peak and equity volatility, while higher, has not surged. As corrections go, the broad market is less than halfway there. 

But, the key point is that the longer the US and China remain at an impasse, so the risk of a nasty bout of stress across markets looms. Even the patient hands of long-term investors need some assurance and traders can use their “insurance” hedging flows to fuel a bigger bout of risk aversion.

Ultimately, a very negative market reaction should in theory bring both sides to the table. Welcome to game theory on steroids. Should we reach that point, investors will be assessing what damage has been inflicted upon the global economy and whether central banks can reset sentiment as relatively smoothly as they did at the start of the year. 

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Quick Hits — What’s on the markets radar

Unicorns must pass cash flow test in public — With shares in Uber falling towards $37 at the open on Monday, the light of public markets is harsh. Having listed last week at $45 a share, Uber, along with its rival Lyft, (below $48 a share on Monday after listing at $72 in late March) are both feeling the valuation heat now they are public companies.

DataTrek highlight a key difference between private and public markets: the importance of positive operating cash flow. 

“Public equity markets don’t care about profits per se, but rather operating cash flow. Uber and Lyft are dramatically short on that count, to the tune of -$1.5 billion and -$1.0 billion respectively last year.”

They add: 

“The bottom line here is that Uber/Lyft/any other cash flow-negative unicorn that wants to go public will be inordinately exposed to the market’s judgment about the cost/availability of future capital.”

The renminbi takes a drop — The offshore renminbi weakened to Rmb6.90 per dollar for the first time in 2019 on Monday. Further weakness looms judging by the pattern of currency options trading on Monday. The one-month risk reversals for the Rmb have risen above last week’s highs as shown below and it is now the highest since November 2016. 

One question at the moment is just how far will Beijing allow the Rmb to slide. A certain amount of weakness will help offset the hit from higher US tariffs, but beyond Rmb7 per US dollar will certainly test financial markets. One point to consider is that as China opens up its financial markets to the rest of the world and more mainland shares and bonds are added to global indices, a currency devaluation will only hurt that long-term objective. 

Some like Marc Chandler at Bannockburn Global Forex think the devaluation card is a step too far for Beijing and says there are other ways to frustrate the US. 

“The lower rungs can be just as effective, even if more subtle, like increased customs scrutiny, more regulatory enforcement, and sourcing from non-US suppliers. It can also quietly frustrate US goals elsewhere, like North Korea, Iran, and Venezuela.”

Watching chipmakers — Few sectors personify the global supply chain quite like semiconductor stocks and that’s why they matter a great deal at the moment. The Philadelphia Semiconductor or Sox index has now entered a correction, having fallen more than 10 per cent from its late-April peak. The issue as highlighted by Matt Maley at Miller Tabak + Co is that before the latest escalation in trade tension, the sector had endured a tough earnings season with poor guidance from many big companies.

As Matt writes:

“This group could be vulnerable even if things calm down on the trade front. Since it’s a key leadership group, that kind of move will be bearish for the broad market as well.”

In turn, that weighs on the S&P 500 tech sector, which has been the big driver of the broad market during the bull run. Not a good development to put it mildly. 

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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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