What Was and Was Not Announced in the US-China Phase 1 Trade Deal
Release the doves. The US and China announced last week that they finally were able to come to terms on the their long contentious Phase 1 trade deal. It seems to have conveniently slipped the market’s collective mind that the first stage of the promised reversal to the trade war was announced back on October 11. No tangible change had been put into place between then and now, but that didn’t slow the climb from risk benchmarks like the Dow. There is very good reason to be skeptical about how committed the two governments are to progress given the numerous starts and stops over the past six months (see the attached chart of the DIA). In an ideal scenario, the two sides flesh out the details to the armistice and offer breathing room to work on the Phase 2 leg.
That said, US President Donald Trump gave a conflicting view of when the subsequent step of de-esclation would take place as he said it could happen before the election in November and then remarked that there was no reason to rush it. There are notably $250 billion in Chinese imports that are still being taxed at 25 percent, blacklisted entities and a currency manipulator designation among other barriers still in place. However, before we assess the difficulties of next steps, it is important to keep close tabs on the presumed efforts for this current chapter. Absent in the announcement were the size of Chinese purchases of US agricultural goods, enforcement procedures, structural change to IP protections, methods of tracking FX manipulation, procedures for dispute resolution or even a clear statement from Chinese officials (through state media) that they are in fact satisfied with the terms.
We shouldn’t view the situation with complete skepticism though as there was very real avoidance of a painful acceleration in their standoff. The US backed off of a planned December 15th increase in the list of taxed imports from China to encompass virtually all of the country’s goods – and China deferred tariffs on US autos. That would have been another severe escalation in the trade war. Further, the White House’s decision to halve the 15 percent tariff rate on the $120 billion in Chinese imports announced back in September is the first meaningful step to actually ease tensions. While this is largely the avoidance of a further step to intensify a painful economic trade war, that may just be enough to stir speculative interest that traders have held on their sleeves.
Risk Trends Now that Our Wishes Have Been Met
Speaking of speculative interest, we should theoretically have all the necessary ingredients to push ahead with a strong close in global capital markets through the year’s end. On a structural basis, we have seen the capital markets climb with little regard to the troubling questions over traditional value for the better part of a decade – perhaps driven by the very generous policies of the world’s largest central banks – and 2019 has been particularly liberal with the buoyancy. Another layer to add to this favorable backdrop is the seasonal expectations associated to the month of December. Historically, ‘risk’ benchmarks like the S&P 500 climb through the final month of the year as much through habituation as anything tangible like tax harvesting. There is a reason it is called the ‘Santa Claus Rally’. And, rounding it all out, we were given a few very high-level, reassuring events to spur a sense of tangible optimism. The Phase 1 trade war agreement and a clear path for the Brexit negotiations between the UK and EU after the former’s general election are a measurable relief to global risk.
With the market’s seeming default optimism, all of this should make for an easy response to extend the bid over November and the first half of December. And yet, this past Friday’s market activity did little to reassure that we were going on cruise control. While measures of implied (expected) volatility dropped in the aftermath of this dual update, the underlying speculative markets would not match with a charge higher. US indices, the best performing of the major assets I follow, marked a technical high with no meaningful progress. Where we could have mustered some conviction through associated risk measures playing catchup to the SPX, there two we were met with hesitation. That doesn’t mean that market has completely blown its opportunity to rouse conviction; but it draws serious, negative attention. A market that rises despite trouble in backing fundamentals and underlying value suggests a speculative default. That same backdrop failing to progress when concrete support is presented is troubled.
The Last Liquid Week of the Trading Year
Liquidity is exceptionally important when you are trading the markets. A good example of what happens at the opposite ends of the spectrum is the day-to-day activity by one of the top shares in the world (say Apple) and those that are on the ‘pink sheets’. The former can build on its gravity to progress a bullish run further than smaller counterparts from sheer size while also curbing panic selling that may otherwise afflict counterparts as its scale can be interpreted as safety. Alternatively, the smallest shares move in often erratic day-to-day swings and frequently see their value wiped out when risk aversion hits the broader financial system. Fundamental and technical analysis counts of course, but market depth and fluidity is a principal influence.
Consider this for what we face over the next two weeks. We are heading into the final thrust of the trading year. Ahead, we face the last full week of the trading year. We’ve seen a clear deference for a risk-on bearing and predisposition towards keeping exposure fairly steady (no profit taking or meaningful hedge build up). Anything other than a slow volume trade of consolidation should be observed closely. A significant climb in capital markets would reflect an ‘all-in’ mentality that would register as quite extreme. Such a climb could be a cue for investors to launch a strong 2020 start, but it could also readily turn into a blow off top when it comes time to reassess value. Alternatively, any meaningful retreat given the prevailing winds, seasonal backing and sliding liquidity could signal risk aversion that is ready to override all the typical hurdles. Be mindful of the market’s next move and the quick assumptions that will be drawn from it.