We are cautiously optimistic about a potential trade deal in March or April.

A trade deal will likely be narrowly focused on increased Chinese imports of U.S. goods as well as China’s approach to intellectual property rights and foreign investment, but will leave many structural issues unresolved. 

Removal of tariffs is a near-term positive, but uncertainty over the U.S.-China economic and trading relationship will remain. 

The macro impact is more about relative winners and losers, with only a small net boost to global growth. A Chinese agreement to buy more from the U.S. will result in redirected trade flows from other trading partners. 

The long-term trends of a) Chinese efforts at supply chain self-reliance and b) foreign multinationals seeking to avoid uncertainty will continue driving both Chinese investment in tech industries as well as foreign direct investment into other Asian markets. 

We see emerging opportunities in a) China’s leading domestic companies that are self-sufficient in securing core parts and technologies; b) regional suppliers as alternative sources of U.S. imports over time; c) suppliers with global sourcing/production capability to mitigate the impact of tariffs (if not removed); and d) companies taking advantage of the Chinese market open-up.

As negotiations between the U.S. and China continue to make progress, we are increasingly optimistic about the prospect for an end to the current trade war. Our view that China and the U.S. can reach a deal rests on two key assumptions. 

The first is that the U.S. wants concessions from China and China is willing to negotiate. What seems obvious now was actually an unknown over most of 2018. 

The second is that the U.S. - primarily President Trump - is willing to settle for less than a ‘grand bargain’ that fully resolves all structural issues between the two economies. 

We think the U.S. will prioritize two key issues - the bilateral trade deficit and better enforcement of intellectual property rights - and other areas of concern such as subsidies, tech transfer and joint ventures could remain unresolved.

Also, it is in these two areas – the bilateral trade balance and IP protections – where China is willing and able to show progress.

That said, any deal will be fairly narrow, and likely accompanied by continued long-term competition between tech sector companies and tensions over market access. 

Furthermore, a trade deal is not uniformly positive. While it could lift sentiment globally, it will also artificially shift trading patterns, meaning more U.S. exports to China could result in less exports from Brazil, Australia, or Taiwan among other countries.

Thus, it’s important to recognize that any U.S.-China deal will create relative winners and losers, and overall growth may not be significantly impacted. 

Above all, we need to recognize that a shift in the U.S.-China relationship has occurred. It used to be about finding avenues for cooperation as a primary goal. That has changed, and the ‘new normal’ will be a state of intensifying competition.

We argue that current Chinese equity valuations have largely priced in expectation of a partial trade deal, given progress already made over the last couple of months. 

If a deal is reached, Chinese import demand will shift towards the U.S. 

However, the areas where the U.S. can substantially expand exports to China are fairly limited and are mainly focused in agricultural products, energy and commodities, and high-tech goods such as semiconductors. This means that countries that currently export these products to China, and in some cases have benefited from the current trade war, could see a significant drop in exports. 

Because such a deal would substantially redirect trade and create relative losers, even among U.S. allies, it raises the prospect that any final deal could be challenged at the World Trade Organization (WTO). 

We think an agreement will not preclude future tariffs in the event tensions worsen in the future. 

And with the long term trends of Chinese self-reliance and foreign multinationals seeking to avoid tariff uncertainty firmly in place, China will continue to invest heavily in domestic semiconductor and software industries, while foreign multinationals will increasingly divert manufacturing foreign direct investment to Southeast and South Asia. 

As we enter a phase of sustained strategic competition between China and the U.S., uncertainty will remain elevated relative to the pre-2016 status quo and risk premia on trade exposed assets will likely reflect that fact. 

While the deal will likely create a mere redistribution between the U.S. and China’s other trading partners, the longer-term positive consequence could be a renewed progress towards market-based reforms. 

Similar to reform efforts during the period when China joined the WTO; spurred by U.S. negotiations Chinese reforms could result in an increase in competition, efficiency and productivity within China.  

Indirectly, China has been pushed to accelerate the opening of the onshore equity market to global investors, including the recently announced new science and technology innovation board. 

China’s stock market has already rerated on expectations of a trade deal. While the MSCI China is now back to its long-term average PE ratio of 12x¹, domestic A shares remain below their long-term average of 15x², which offers potential investment opportunities. 

Notably, as the deal could point to increased imports of U.S. goods, China would likely see its trade surplus erode over time, posing downward pressure for the Renminbi.

In the short term, trade-sensitive sectors such as tech hardware may enjoy a relief rally following a deal. This sector includes companies along the supply chain for the key American smartphone brand, which generate most of their sales from the U.S. across various sectors. 

However, we would take profit on those names into any rallies as the trade relationship between the U.S. and China shifts structurally.

Over the longer term, we believe there are four areas that present interesting opportunities: