Only a brutal shock will free markets whipsawed by trade fear

Only a brutal shock will free markets whipsawed by trade fear

The investment playbook over the past 18 months during the US and China trade dispute has been one of ignoring the short-term noise and waiting for a buying opportunity.

Bouts of financial turmoil that knock down equities and other risk assets have been followed by periods of relative calm that spurred a rebound in sentiment and market performance.

This pattern of escalation and partial retreat between the US and China has now become a lot more challenging as big lines have been crossed in recent days.

The People’s Bank of China has spent billions in reserves ensuring the renminbi would hold the line below Rmb7 per dollar, only for rising discord over trade and a slowing domestic economy to weaken the central bank’s resolve.

This line in the sand at Rmb7 per dollar was washed away last Monday and duly triggered nasty flashbacks to earlier bouts of a weaker Chinese currency. These include the surprise devaluation in 2015 and a slide during the summer of 2018, both of which fanned plenty of broader global turmoil.

The PBoC’s tolerance of a weaker renminbi this week was swiftly followed by the US Treasury labelling China as a currency manipulator, a charge that looks many years late and more an effort to stem a bout of pronounced renminbi weakness.

Left to market forces, rather than the PBoC’s managed float, the renminbi would be a lot weaker, following the path of other currencies that have been steamrollered by a rampant US dollar since April 2018.

Together, these actions signal no short-term trade deal or resolution at hand between the two powers (due to meet for further talks in September), which leaves financial markets at the mercy of the next official salvo that ups the stakes.

The risk remains that tariffs climb to 25 per cent for all Chinese goods and the renminbi, acting as a safety valve for the economy, then weakens further and triggers US currency intervention.

Hardly soothing the apprehension among investors is the argument in some quarters that both countries have time on their side.

This suggests that the US Federal Reserve and the PBoC have room to ease a lot more should economic data deteriorate, while Wall Street and Chinese equities are still up significantly in the year to date.

That leaves the global economy and business investment looking on grimly, a hostage to a growing war of words and retaliatory actions between Beijing and Washington.

Given that much of the rebound in global equities from late December reflected faith in a trade deal being struck and China stimulus bolstering demand well beyond its shores, there is room for a substantial equity correction.

Optimism that drove US equities to a record high in late July ignores the risks of a substantial impasse between the US and China.

A stronger shock registered among emerging market currencies and shares, with the typical lack of market liquidity in August hardly helping to smooth the clamour for the exit.

Both EM equities and currencies are testing multi-month lows. That means borrowing in euros and the yen to fund the purchase of higher-yielding EM assets, known as the carry trade, is a strategy that may start being unwound.

In contrast with recent corrections — seen in May, and early and late last year — buyers of the dip have to acknowledge that global growth is now in a much weaker state.

Investors need to balance a slower pace of earnings growth against the limits of monetary policy.

Traders who have been stockpiling cash and rotating their portfolios towards quality assets may well anticipate a buying opportunity ahead of central banks speaking at their annual gathering at Jackson Hole later this month.

This is an understandable strategy, except that the promise of substantial monetary easing and ever lower bond yields that help support asset valuations won’t alter the dynamic between the US and China, let alone stem the next bout of trade-induced markets turmoil.

What is necessary to break the pattern of escalation and retreat is a brutal market shock that prompts detente between Washington and Beijing and removes the uncertainty facing business investment and global trade.

In that respect, a significant drop in US equities stands a better chance of convincing US president Donald Trump that his current course of action is not a winning hand.

As Win Thin, at Brown Brothers Harriman, argues: “Simply put, China will not give in to threats and intimidation and so it will be up to the US to take a step back in order to move the ball forward.’’

michael.mackenzie@ft.com

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