Hopes of a détente in U.S-China relations have risen ahead of a President Donald Trump and President Xi Jinping meeting on the sidelines of the G20 summit. Risky assets most rattled by tit-for-tat trade actions have perked up relative to global markets. Yet we are wary of chasing any near-term bounce. The tussle between the two countries extends well beyond trade issues and is likely to endure, in our view.
Our BlackRock Geopolitical Risk Indicator for U.S./China relations shows that market attention towards risks of a flare-up between the two countries is high. Yet constructive signals from both countries in the run-up to the Trump-Xi meeting in Buenos Aires has pulled the BGRI significantly off its 2018 peaks. Our analysis shows material shifts in the U.S.-China BGRI coincide with large swings in prices of cyclically exposed assets sensitive to this risk, as shown in the chart. Among the myriad factors driving asset prices, political risks have a bigger impact when market attention to them shifts rapidly. Yet we find this relationship tends to be stronger over shorter time horizons. Over longer windows, factors beyond geopolitics reassert themselves to drive market returns.
China in the spotlight
A series of overtures from the U.S. towards several trading partners has taken some of the sting out of escalating global trade tensions. The U.S. investigation into auto imports on national security concerns is still ongoing, yet a convivial meeting between Trump and the EU’s Jean-Claude Juncker helped calm fears. A revised trade deal between the U.S., Mexico and Canada will likely go before Congress next year. The U.S. signed a trade agreement with South Korea. Bilateral negotiations with Japan passed without conflict.
China stands apart. The U.S. tussle with China has so far focused primarily on tariffs. The current 10% levy on $200 billion of Chinese goods imported to the U.S. will rise to 25% in January unless it is halted. And a threat to extend tariffs to all Chinese imports still looms large. Yet we believe trade tensions are just one facet of a competitive phase in U.S.-China relations that is in its early days. The best outcome for risk assets at next week’s meeting in Buenos Aires? The U.S. hitting pause on the tariff escalations and a commitment to work toward a broader framework for trade. We believe a temporary truce will not be enough to clear longer-term clouds. Business confidence in China and in pockets of the U.S. has already taken a hit, potentially spurring caution in long-term corporate spending plans. The risk to the downside is stark: A lack of progress in the talks could reignite fears of a devaluation in the Chinese yuan. Assets sensitive to risks of worsening relations–such as broad Chinese equities, Asian tech supply chain stocks and small-cap material shares–could see another leg down.
The real issue for both sides is the competition to dominate the technologies and industries of the future. Thorny relations between the world’s largest economies are a source of macro uncertainty–and an important reason for seeking increased portfolio resilience, in our view. We see quality-style equities and short-dated U.S. government bonds as two ways to increase ballast within portfolios. We also look to identify areas of the market that now reflect significant downside risks, such as Chinese and other emerging market equities, where the de-rating in 2018 looks to have created an attractive entry point for long-term investors.