When it comes to the near- and medium-term trajectory of the market, there were two events that mattered: as we summarized back on June 14, the first major catalyst was last Wednesday’s FOMC meeting, where Powell had a choice – lose the “patience” and end the rate hike cycle or stun the market risking a crash, and continue tightening financial conditions. Of course, as everyone knows by now, “Powell threw in the towel”, capitulating to both the market and president Trump’s relentless barrage and confirmed that a July rate cut is virtually assured, at least according to the market which now see greater than 100% odds of such an event. The second catalyst is next week’s G-20 summit in Osaka, Japan, where Trump will meet with China’s president Xi and perhaps put an end to the trade war.
The updated 2×2 matrix from Bank of America of these events is shown below, with the hawkish FOMC outcome no longer in play.
However, unlike the FOMC where a dovish outcome was virtually assured, a fvorable outcome next week is a far less likely outcome. Indeed, as we noted last Wednesday, Goldman has created a “barometer” index tracking the probability of a trade resolution. It now stands at just 20%, or a one in five chance that the two superpowers will find an amicable resolution, and while this is up from 7% one month ago, it is down from 80% back in March.
So does that mean that traders betting on a bullish outcome from this week’s main event should start buying puts? According to a Friday follow up analysis from Goldman’s chief political economic, Alec Phillips, the answer is “while the meeting between Presidents Trump and Xi at the G20 meeting will clearly be an important event for financial markets, it seems unlikely to be decisive, as the odds of a formal detailed agreement at the meeting seem very low”, although the silver lining is “that further tariff escalation would probably not be announced right away either.”
This in turn means that both sides will seek to kick the can and avoid the downside scenario portrayed by BofA which sees the S&P dropping to 2,750, propped up by the backstop of the newly-dovish Fed.
Here is what Phillips believes is the most likely outcome from next week’s G-20 meeting which the Goldman strategist dubs “A hiatus, not a breakthrough.” Below is the executive summary:
The G20 meeting is important but is unlikely to be decisive. Financial markets are once again focused on trade policy, in anticipation of the upcoming meeting between President Trump and President Xi at the G20 meeting in Osaka, Japan (June 28-29). However, we do not expect whatever announcement they make following the meeting to provide very much clarity on whether the US has finished increasing tariffs or whether a deal will eventually be reached with China. While we can imagine several potential outcomes from the upcoming meeting, the most likely outcome seems likely to prolong trade policy uncertainty.
So while continuation of the status quo is the most likely outcome that is announced next Saturday, what are the nuances? Below we repost some of the key observations by Phillips:
A formal agreement at the G20 seems very unlikely. There has been little communication among US and Chinese officials since talks broke down over a month ago, and discussions over the next week seem insufficient to result in a formal detailed agreement. Chinese officials might also look at the tariffs that President Trump recently threatened on Mexico as a sign that reaching a formal agreement (as the US and Mexico did in the USMCA) might not be sufficient to eliminate the risk of tariffs, which would reduce their incentive to offer concessions.
Immediate post-G20 escalation is possible but fairly unlikely. The public comment period on the next round of tariffs ends July 2, after which the White House would be free to issue a final tariff notice on imports from China (implementation of tariffs would probably take another couple of weeks). In light of the breakdown in talks in early May, there is clearly a chance that the two leaders might be unable to reach even a preliminary understanding. If so, we expect that President Trump would indicate that additional tariffs would be imposed, as the time to negotiate an agreement before the 2020 presidential election is growing shorter, and we expect that President Trump would be unwilling to postpone further tariffs if he believed there was little chance of reaching a deal without further pressure. While we view this as a possibility, we think immediate escalation is fairly unlikely.
A commitment to re-engage seems the most likely outcome. US officials, including President Trump and US Trade Representative Lighthizer, have emphasized their interest in restarting talks. In the two analogous face-to-face meetings that President Trump previously held with foreign leaders—with European Commission President Juncker in July 2018 and President Xi in December 2018—he agreed to postpone tariff increases in return for an unspecified commitment to negotiate an agreement. This seems to be the most likely outcome once again.
The White House might set a new deadline. We note that the only agreements the White House has reached with major US trade partners have come at the last minute ahead of clear deadlines. USMCA was finalized on August 27, 2018, just a few days before an important procedural deadline. More recently, Mexico agreed to an immigration-related deal less than three days before tariffs would have taken effect. By contrast, the White House indefinitely delayed the step-up in the tariff rate from 10% to 25% on $200bn of imports from China, and talks ultimately broke down. While imposing a new deadline on negotiations might add counterproductive public pressure on China, it would not be surprising for the White House to take this approach in light of the failure of open-ended negotiations to produce agreements.
A pause in escalation in the near-term could still lead to additional tariffs later this year. In the two analogous leader-to-leader meetings noted earlier, President Trump agreed to postpone further tariffs. However, in both cases, this détente was only temporary, as the White House eventually imposed additional tariffs on imports from China and has indicated it will impose auto tariffs on the EU and Japan if an agreement is not reached by November.
Financial markets do not appear to be an obstacle to tariff escalation… The last two times President Trump seriously escalated trade tensions with China, the S&P 500 was near record highs. By contrast, President Trump’s decision to delay tariff escalation in December 2018 came after two months of equity market declines. The S&P 500 closed on June 20 slightly higher than its level during the prior instances of escalation, suggesting that concerns regarding financial markets are unlikely to deter the White House from imposing tariffs.
…And monetary policy considerations might motivate the President to prolong trade policy uncertainty. One of the factors that led financial markets to reprice expectations for monetary policy is rising trade policy uncertainty, as demonstrated by the sharp repricing in fed funds futures after the President proposed tariffs on Mexico on May 30. More recently, Chair Powell’s press conference comments also referenced trade policy uncertainty. While it seems unlikely that President Trump had monetary policy in mind when he made the latest round of tariff proposals, we would expect that the President now views tariff threats as not only a successful negotiating tactic following the immigration agreement with Mexico but also a useful tool in pressing for looser monetary policy. If so, this suggests that the White House will at least threaten further tariff increases and might follow through with some of them.
Tariffs still seem more likely to rise before the 2020 presidential election than to hold at current levels. While it is a close call, we still think tariffs are slightly more likely to rise further over the next several months. The White House seems likely to continue to use tariff threats as a negotiating tactic. However, since not all trading partners will be willing to make the concessions the US wants, it seems likely that at some point the President will follow through with at least one of the tariff increases he has proposed. It is hard to predict when this will happen or on which imports. A further increase in tariffs on imports from China seems more likely than other targets, since the White House has already formally proposed further tariffs and will be in a position to impose them in July, and political support for tariffs on imports from China is still much greater than support for tariffs on Mexico or the EU.
However, we doubt that the White House will impose a 25% tariff on all remaining imports from China. Our expectation continues to be that the Trump Administration will impose a 10% tariff on remaining imports from China to reduce the economic disruption and impact on consumers that a 25% tariff would have. We note that in congressional testimony this week, USTR Lighthizer described the pending tariff notice as providing authority to impose tariffs of “up to 25%”.
A “deal” between the US and China seems more likely than not prior to the 2020 election. Like most other aspects of the trade policy outlook, this also has become a closer call. We believe that President Trump will want to demonstrate success in the US-China negotiation prior to the 2020 election, which could bring him to accept a deal that stops short of the agreement that the US sought a couple of months ago. That said, while the political pressure to reach an agreement will increase as the election approaches, the political scrutiny of the specifics of the agreement will also increase. Since domestic political pressures in the US and China will push against either side making meaningful concessions, we expect that the most likely scenario for an eventual deal would be for a few genuine reforms coupled with a commitment to purchase a substantial amount of US exports, in return for a phase-out of US tariffs.
Of all of the above – much of which focuses on the period 6-9 months ahead of the 2020 elections and is therefore less relevant for the immediate future, the one aspect of Goldman’s analysis we find most relevant (and credible) is the bank’s consideration of interplay between trade policy – and trade war – and Trump’s growing indirect influence over the Fed, to wit:
… we would expect that the President now views tariff threats as not only a successful negotiating tactic following the immigration agreement with Mexico but also a useful tool in pressing for looser monetary policy. If so, this suggests that the White House will at least threaten further tariff increases and might follow through with some of them.
As was extensively reported last week, Trump considered firing or demoting Powell at the start of the year; realizing he can’t do so directly, he instead decided to pressure Powell to do his bidding in response to Trump’s actions!
To be sure, by now Trump has certainly figured out that his strongest leverage over the Fed is by escalating the uncertainty in the trade and political arena, forcing the Fed to tip its cards and unveil its open-ended dovish policy which the market now expects will result in as many as 4 rate cuts in the next 12 months, setting up Trump nicely for the election, with the S&P at or near all time highs, even if the overall economy continues to deteriorate (it is, however, unclear how much longer markets will ignore the growing risk of a recession just because the Fed has promised to cut rates further).
As such, if Trump feels the need to extract more concession from Powell, all he needs to do is to make good in part or in whole on his $300BN in new Chinese tariffs, which will force the Fed to take on an even more dominant role to preserve the economic cycle by doing the only thing it knows how to do: push assets to new all time highs with even more dovish policies.
And since for Trump the stock market is the only barometer that matters for his “approval rating” as today’s tweet on the topic confirmed…
Stock Market is on track to have the best June in over 50 years! Thank you Mr. President! @WSJ
— Donald J. Trump (@realDonaldTrump) June 22, 2019
… the perverse outcome is that the White House is now confident that the more it pushes China – in word or in deed – toward a full blown trade war, the more Powell will be forced to concede to Trump in the simmering feud between the executive and the money printing branches of US government. Which is why, even if Goldman is confident that a perpetuation of the status quo is the most likely outcome, traders may be wise to buy the occasional put: if Trump really wants the Fed to consider doing QE (or more), all he has to do is to achieve a total collapse in trade with China, which will leave the Fed, and its money printers, the last recourse the US has to avoid a recession, effectively taking the ball out of Trump’s court and strategically putting it into Powell’s, where depending on what Powell does, the consequences could be dire on both sides: as DB’s Aleksandar Kocic explained earlier:
In the case of unresponsive Fed it is a recession, while in the case of an accommodative Fed it is the loss of central bank independence and potentially another round of trade wars and even more pressure on the Fed to cut rates with further markets addiction to stimulus and possibly higher inflation etc.
What is most surprising about all of the above, is how skillfully Trump played both China and the Fed to get his desired outcome: a continued belligerent stance with his superpower adversary even as Powell – who is hardly Trump’s biggest fan – is forced to do everything in his power to protect Trump’s back.
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