US-China trade: tariff relief
The US and China have announced a temporary tariff reduction for 90 days following their trade talks in Geneva over the weekend. The US will reduce the reciprocal tariff rate on China from 34% to 10%, the same tariff rate as for most other countries, and will completely eliminate the retaliatory tariffs of 91% that were imposed in April. The new effective US tariff rate on China is around 40%, significantly lower than before.
China is also reducing its retaliatory tariffs to 10%, bringing the effective tariff rate on US goods to around 25%. In addition, China will remove the nontariff countermeasures it has imposed against the US. This significant de-escalation goes beyond what was widely expected and marks a positive development for US-China trade relations. Nevertheless, there is still a high degree of uncertainty regarding the outcome of the upcoming negotiations, which could involve some back and forth over the coming months.
The US tariff rate is no longer at a level that is prohibitive for trade
The de-escalation in the US-China trade conflict should reduce some of the drag on Chinese exports. While the US tariff rate on Chinese goods is still significantly higher than before President Trump took office, and relative to the US tariff rates on other countries, it is no longer at a level that is prohibitive for trade.
The Chinese trade data for April showed that China’s exports to the US declined by 21% year-on-year. Overall, however, Chinese exports remained resilient in April. A sharp increase of exports to Southeast Asian economies suggests that at least some of the trade flows to the US may have been rerouted via other countries. This could continue in the coming months, as the US tariff rate on China is still significantly higher than on other economies.
Market reaction: Likely positive, mixed with fear about new headlines
As the market expectation over the weekend was for the US tariffs on Chinese goods to be cut to 45%–60%, the tariff cut to 30% is certainly a positive surprise for the market. This trade truce has given reasons for the market to cheer initially, although the bigger question is what will happen after 90 days.
We studied the Trade War 1.0, which can be loosely divided into three phases:
- The first phase started in early 2018, as the US successively imposed tariffs on Chinese goods that were met with Chinese retaliations, and lasted until US President Trump and Chinese President Xi met at the G20 Buenos Aires Summit in December 2018, where the start of trade negotiations was announced.
- The second phase featured multiple twists and turns until October 2019, when the two nations reached a tentative agreement for the Phase One trade deal. In those months, the Chinese stock market saw a lot of volatility with only modest returns.
- The third phase from October 2019 enjoyed solid market optimism until the deal was officially signed in January 2020 and the Chinese index peaked.
Using the Trade War 1.0 template, we believe we are now in the second phase. The initial reaction from here is likely positive, but the market may still face unfavourable headlines that dampen investor sentiment. Furthermore, sector performance since 2 April suggests that the market has priced in strong domestic stimulus that potentially offsets the negative impact from trade, resulting in the overall index nearing pre-Liberation-Day levels. We believe there is still room for US-exposed Chinese stocks to further reverse their underperformance vs domestic consumption names, but it may take a longer time and a bumpier path for the overall market to surpass its previous high. Finally, China’s Q1 reporting season is entering its final weeks, so the earnings announcements may also influence market sentiment in the near term.
Investors should use this breather to regroup
So is everything back to normal? Not quite. The trade warriors have forged an intermediate truce, and bourses have been fast and furious to price it in. From here on, the risk landscape should morph into the usual pullbacks from deals, plus the whims of further executive orders, and investors should use this breather to regroup. Higher tariffs across the board will take their toll on growth. This trade deal leaves room for lower rates and self-help on fiscal spending, which is what markets are telling us with their upbeat reception of the news, particularly for Europe and China. As for the US, the opportunity may lie more in removing red tape and easing corporate executives out of the trade disruption trauma and into executing their expansion plans.
Where does that leave the risk landscape? We believe that the main risk lies in the ‘art of the deal’ yet again. This is because the US playbook for hammering out deals includes the option of leaving the bride at the altar, i.e. pulling out of the deal when everything is ready just to get a final benefit. The other aspect of Trumpian deal making is the “if you cannot convince them, confuse them” approach, which leaves plenty of executive orders that could be directed at particular sectors, such as, most recently, the pharmaceutical sector. Where does all of this leave the investment side of things? Traders may want to trim their holdings after the fact. Investors can continue to regroup both from a regional and single-security point of view.