China-U.S. Feud Fuels Haven Demand as Traders Rewrite Playbook

(Bloomberg) Forget all the optimism that briefly reverberated through markets over trade on Friday. The weekend’s events have reshuffled the deck and traders are once again looking toward haven assets.

Fresh tweets from President Donald Trump and threats of retaliation from China mean investors can expect that the end-of-week gains triggered by the U.S. government’s characterization of the negotiations as "constructive" are likely to evaporate quickly as various markets open up again.

Early trading in currency markets Monday showed demand for the relative safety of traditional havens such as the Japanese yen, while the Chinese yuan was weaker and trade proxies like the Australian and New Zealand dollars were weaker. At the same time, moves were relatively contained amid thin trading in the early Asia-Pacific hours and the real test may come as markets from equities to Treasuries get going later in the day.

“In little over a week we have gone from trade-news euphoria to total misery,” Stephen Innes, head of trading at SPI Asset Management in Hong Kong, wrote in a note Saturday. “But by all accounts markets are less about the immediate economic fallout and more about just how much damage has been done to the trade process and whether a compromise can be reached.”

Exactly what has been priced into markets from the escalation of trade tensions -- and what still needs to be priced in -- is a riddle that investors the world over are urgently trying to solve. And, frustratingly, attempts at answers tend to come in three parts, depending on whether this latest escalation manages to trigger a trade agreement in the near term, a longer period of back-and-forth brinkmanship or a full-blown trade war.

For now, traders are taking the latest utterances from the two sides as a sign that the standoff will endure, at the very least. After raising tariffs on $200 billion worth of Chinese goods and threatening more on Friday, Trump said Saturday it would be wise for China to “act now” to complete a trade deal with the U.S.

Larry Kudlow, Trump’s top economic adviser, tempered the remarks later, saying on Fox News that Treasury Secretary Steven Mnuchin and Trade Representative Robert Lighthizer have been invited back to Beijing for more talks. The U.S. is still in a “negotiation,” not a “war” with China, he said.

Still, Trump’s tweets had enough force to prompt China into vowing retaliation. And in an article to be published Monday in the People’s Daily, the flagship newspaper of China’s Communist Party, the Chinese said the U.S. should take full responsibility for the setbacks because it raised tariffs on the country’s products, according to state television.

Earlier, in an interview with Chinese media after the talks in Washington on Friday, Vice Premier Liu He said that to reach an agreement the U.S. must remove all extra tariffs, set targets for Chinese purchases of goods in line with real demand, and ensure that the text of the deal is “balanced” to ensure the “dignity” of both nations.

Pricing It In

“The FX market is pricing trade tensions but not a trade war,” Bank of America economists led by Ethan Harris wrote in a note last week. “Importantly, the markets could view brinkmanship as similar to a trade war in the short run. By contrast, we think the rates market is already pricing in something like the brinkmanship scenario,” which could continue for weeks.

A U.S.-China agreement in the near term naturally would provide the best chance for traders to pick up the scraps of their old playbooks and tape them back together.

The chance of a prolonged period of tensions, though, has strategists conjuring up a wide variety of investment ideas.

Credit Suisse suggested a trade that benefits if the iShares MSCI Emerging Markets ETF falls between 4.5% and 8% over the next month. UBS Global Wealth Management decided to end its recommendation to overweight emerging-market hard-currency sovereign bonds.

The consensus appears to have gravitated toward the idea that prolonged or escalated tensions would extend the past week’s trends: weakness in emerging-market currencies and global equities, gains in haven assets such as the Japanese yen and U.S. Treasuries -- and heightened volatility just about everywhere. China’s yuan, Thailand’s baht and the Philippine peso are the most at risk in a trade war, according to a Bloomberg Intelligence model.

“Forward-looking currency markets are reacting to the prospect of China’s trade surplus falling and Chinese corporates with $840 billion of onshore foreign-exchange loans pre-emptively buying dollars,” Mansoor Mohi-uddin, the Singapore-based senior macro strategist at NatWest Markets, said by email Sunday. “Similar behavior last year caused the exchange rate to rise from 6.25 to 6.95” against the U.S. currency.

The onshore yuan closed Friday at 6.82 per dollar. Markets in Hong Kong are closed for a holiday Monday.

Before the Trump tweets heard around the world, a central thesis in markets was that a trade deal and economic stimulus in China would boost riskier assets at the expense of havens, causing Treasury yields to rise in the second half of the year, Jim Caron, fixed-income portfolio manager at Morgan Stanley Investment Management in New York, said in an interview.

“Now the thesis is that, based on what we’re seeing right now, it seems as though China has backed out of a deal and why that’s significant is that this isn’t just something that can be fixed by a tweet -- he just can’t untweet that,” Caron said. “I’d argue that we have to believe that the surprises in the market are going to be more toward the downside than the upside.”

Managing Risk

He’s not the only one bracing for more risk aversion. Investors need to be ready for the trade war to get worse before it gets better, risking further weakness in stocks that were already vulnerable after strong gains to start the year, Shane Oliver, head of investment strategy and chief economist at AMP Capital, wrote in a note.

Miller Tabak & Co. equity strategist Matt Maley sounded a similar note of caution and said that a 10% drop in the S&P 500 Index from its recent high would not be out of the question. So far, the gauge has fallen less than 3% from its record high close at the end of April.

“The stock market was already ripe for a pull-back,” Maley wrote to clients. “Now that it’s getting some negative news -- materially negative news -- it’s even more ripe for a larger decline. Therefore, we believe investors should not be trying to figure out whether the market will decline or not. They should be trying to figure out how much it will fall.”

Meanwhile, although U.S.-China scenario analyses dominated the past week, the focus could quickly shift. Janelle Woodward, head of fixed income at BMO Global Asset Management, has an eye on the next potential target for tariffs: European automakers. The Trump administration was expected to make a decision on the findings of a probe into the national security risks of European auto imports by May 18.

“We think there are a lot of options as far as extension or asking for a new investigation, but this does seem something that hasn’t gotten a lot of press given the situation with China,” she said.


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