An interim trade deal is no panacea

The US-China trade conflict remains a key near-term variable for the equity market.An interim agreement, if reached, would remove a source of downside risk.

US President Donald Trump now appears more willing to consider a partial deal, and – provided it is based on “mutual respect" – we think that China may agree. In our view, this means two-sided enforcement mechanisms and reciprocity in areas such as intellectual property and market access.

But it isn’t yet clear that an interim deal that kicks trade worries down the road would be sufficient to allay concerns about the geopolitical, economic, earnings, and policy backdrop:

A trade deal might not be trusted.

• We think President Trump’s announcement of a Chinese commitment to buying USD 40–50bn of US agricultural products appears unrealistic – US exports to China peaked at just USD 26bn in 2012, when prices were much higher. A shortfall in agricultural purchase commitments might well lead to a re-escalation in the conflict further down the road.

Economic data remains mixed.

• Trade uncertainty has weighed on business investment while consumption has remained robust. Recently, there have been early signs of stabilization in capital expenditure, which we think may have already slowed to maintenance levels, suggesting limited further downside. Growth in OECD capex declined from an annual rate of 5% in mid-2017 to less than 1% in 1Q19, but it ticked higher in 2Q19, the latest quarter for which data is available. That said, last week’s US durable and capital goods orders for September showed a further decline, suggesting it’s premature to expect a sharp rebound in business investment, which makes sense given the risk of re-escalation.

Recent indicators regarding the consumer and employment have also been less encouraging. In September, US retail sales unexpectedly dropped for the first time in seven months. Elsewhere, the US ISM non-manufacturing employment component fell to its lowest level since 2014.

We see scope for some disappointment in earnings.

• Global earnings are expected to rebound in 2020, with consensus forecasts of roughly 10% growth. We think US earnings will modestly bounce back next year, after coming in roughly flat in 2019. Although we forecast just 5% earnings per share (EPS) growth for the S&P 500 next year, versus consensus of 10%, this gap is close to normal given the trend for bottom-up estimates to be revised down over the course of a year.
• In Japan we expect EPS growth of 1% com¬pared with market forecasts of 6%, but this gap is also relatively small. However, we think analysts may be too optimistic on EM and Eurozone earnings. The gap between our estimates and consensus is widest in the Eurozone, where we expect full-year EPS to contract by 3% in 2020, compared with consensus forecasts for 10.5% growth. In emerging markets, our estimate is for 6.5% EPS growth next year versus a consensus of 14.1%.

The policy outlook remains supportive of continued sluggish expansion.

• We remain confident that central bank monetary policy actions will continue to limit the risk of a US or global recession and of a major sell-off in risk assets. But, despite calls for greater use of fiscal expansion from outgoing ECB President Mario Draghi and others, we continue to doubt that policymakers are in a position to act pre-emptively and drive meaningful upside in the economy or risk assets. The Eurozone remains constrained by budget rules, Congress will block further fiscal expansion in the US for at least another year, and China will likely remain focused on the risk of rising debt.

After a strong year for balanced portfolios, we think it is prudent to be more critical about the current valuations, growth, and geopolitical outlook. It is certainly possible that equities finally break out of their last six months’ trading range in the event of, for example, a positive surprise on US-China trade such as an indefinite suspension of the December tariff increase, or a better-than-expected recovery in manufacturing.

But, on balance, we continue to focus on earning yield rather than looking for higher equity prices. We maintain a modest overall underweight to equities with a preference for US and Japanese equities relative to Eurozone stocks, which reflects our view on the relative earnings outlook. In emerging markets, we prefer USD-denominated sovereign bonds to stocks.

Bottom line

The US-China trade conflict remains a key near-term variable for the equity market. Both sides appear willing to reach a partial agreement focused on existing tariffs and Chinese agricultural purchases. But a deal is by no means certain and might not be sufficient to allay concerns about the geopolitical, economic, earnings, and policy backdrop. A trade deal might not be trusted, global growth is slowing, earnings could disappoint, and business investment is unlikely to pick up markedly. Central bank policy, while supportive, is unlikely to drive markets much higher from here. Against that backdrop, we maintain an underweight to equities.

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