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Geopolitics Offer a Gift—but Markets May Return It

Wells Fargo Investment Institute - December 13, 2019

by Paul Christopher, CFA, Head of Global Market Strategy

Key takeaways

  • Nearly simultaneous political developments in long-running negotiations appeared to reach new and positive clarity during the week of December 9, sparking a rally in risk markets and a rise in interest rates.
  • The convergence of these positive geopolitical developments before investors can turn the calendar to 2020 is significant in degree as well as timing, and it may give risk markets further room to rise in the coming days or weeks.

What it may mean for investors

  • However, it is not clear that even multiple reinforcements in sentiment will change the economic trends and political obstacles that remain in place. We continue to favor caution; we believe that investors should stay close to their long-term allocations and weigh the risk of short-term rallies that may reflect relief but no improvement in fundamentals.

“Now this is not the end. It is not even the beginning of the end. But it is, perhaps, the end of the beginning.” —Winston Churchill

Nearly simultaneous political developments in long-running negotiations appeared to reach new and positive clarity during the week of December 9, sparking rallies in risk markets and a rise in interest rates. Global equity prices, bond yields, and most commodity prices rose, while perceived safe havens in gold and the U.S. dollar were broadly weaker. Three events seem mainly responsible for the market moves:

  • In the U.K., Conservatives won a decisive majority in the House of Commons, a vindication for Prime Minister Boris Johnson’s plan to withdraw from the European Union (EU) on January 31, 2020. After withdrawal, the U.K. would then have 11 months under existing trade arrangements to negotiate new trade terms with the EU.
  • The leaders of the U.S. House of Representatives announced an agreement in principle with the White House on a revised North American free trade agreement (the U.S.-Mexico-Canada Agreement, or USMCA). A House vote by year-end is likely, with Senate ratification potentially as soon as January 2020. We expect Mexico and Canada to ratify the deal promptly.
  • President Trump signed off on a “Phase 1” trade deal with China. Although it is limited in scope, the agreement includes important provisions to maintain global economic growth—including suspension of U.S. tariffs threatened for December 15 and possible rollbacks of existing tariff rates by up to 50% on $360 billion of Chinese imports—in exchange for China agreeing to specific amounts of U.S. agricultural purchases.

The convergence of these positive geopolitical developments before investors can turn the calendar to 2020 is significant in degree as well as timing, and it may give risk markets further room to rise in the coming days or weeks. These events reinforce our outlook for global economic stability and a moderately weaker U.S. dollar. However, it is not clear that even multiple reinforcements in sentiment will change the economic trends and political obstacles still in place.

Our perspective

  1. Markets have anticipated good news for nearly two months—it’s not clear how much upside remains: From the announcement of new British elections until the Election Day (October 15-December 12), the British pound appreciated by roughly 6.75%. Over that same period, markets also anticipated a “Phase 1” U.S.-China trade deal, and the S&P 500 Index rose by 14.36%.
  2. As in Mr. Churchill’s words, this week’s events may be only the end of the beginning:

    Regarding Brexit: The reaction to an imminent end to the impasse should be tempered by the great difficulty of negotiating a new EU-U.K. trade agreement by December 31, 2020. Past EU trade deals have taken years to conclude. But without an agreement by 2021, EU-U.K. trade would default to unfavorable terms, including sudden EU tariffs on U.K. exports. The U.K. could request an extension by July 2020, but the government says that it will not do so. Investors may see more of London’s last-minute, nail-biting extension requests.

    Regarding U.S.-China trade: The Phase 1 deal is almost as narrow as we expected, and China still argues that it should not have to commit to buying more U.S. goods than its consumers need, nor at higher prices. If China purchases less than promised, the deal calls for the U.S. tariffs to snap back. More significantly, the deal does not address the main (and much more difficult) issues of China’s industrial subsidies and forcing foreign firms to transfer their intellectual property to Chinese firms as a condition to enter Chinese markets.

    Regarding USMCA: The new agreement is unlikely to raise U.S. economic growth significantly, in part because the deal compels higher Mexican wages, much closer to U.S. wage levels. These higher wages could raise U.S. automobile prices and potentially encourage U.S. firms to relocate manufacturing outside of North America. These losses to the U.S. economy may be offset to some extent by the USMCA’s new intellectual property protections and new rules for e-commerce, as well as its inroads for U.S. dairy farmers in Canada. 1

  3. Future U.S. trade policy remains unclear: The two trade deals mark a distinct change from the predictable and low-tariff multilateral agreements of the past. Both deals announced this week point out the new prominence of bilateral negotiating, and especially the role of tariffs to build negotiating leverage. We should expect more trade policy uncertainty as the U.S. and other countries may exchange tariffs as suddenly as investors have seen in the past two years. In this new environment, the longer a company’s international supply chain is—and the more that company relies on large overseas facilities to reduce per unit costs—the more vulnerable its earnings would be to the unpredictability that comes when the U.S. uses punitive measures (tariffs and other measures) for leverage on one country at a time.

  4. The global economy may not accelerate much: Political success supports sentiment, but the recovery from 2019’s global economic slowdown seems much more shallow than those of 2012 and 2015 (Chart 1), for two reasons:

    China is very unlikely to stimulate the global economy to faster growth. For the past 18 months, Beijing has used just enough economic stimulus to keep economic growth steady. The total credit impulse (change in credit as a share of change in economic output) is flat and no longer supports global manufacturing activity (Chart 2), unlike in 2012-2013 and 2016, the last two mid-cycle slowdowns of this expansion. We expect Chinese 2020 economic growth of 5.8%, but Beijing’s full-year 2020 target is 6.0%, implying that any domestic stimulus may be limited. Consequently, global manufacturing does not have the key support from China that was essential for recovery after this expansion’s earlier slowdowns.

Chart 1. Leading indicators suggest a slow and shallow global recovery (12-month percentage change)


Chart 1. Leading indicators suggest a slow and shallow global recovery (12-month percentage change)

Sources: Bloomberg and Wells Fargo Investment Institute, December 12, 2019. Monthly data, October 2010 – October 2019. Global leading indicators are represented as a 12-month percentage change for the Organisation for Economic Co-operation and Development (the OECD), which is an association of 36 of the largest economies in the world.

China’s domestic policies partially offset the encouraging geopolitical news. China is reorienting its growth to domestic sources, especially technology production. In 2019, new credit went into spending on computers and communications equipment (Chart 3), not into construction. This is important, because Chinese construction spending fuels demand for commodities (from emerging economies) and equipment (from Europe and Japan). China no longer needs to import as much from these traditional export partners. In fact, exports to China from Taiwan, Korea, and Japan rolled over again in the final four months of 2019. It is not clear yet what will drive a global manufacturing recovery, but investors should not assume that past patterns will repeat with the same strength. Without additional spending growth, it is difficult to see how interest-rate cuts can raise global economic growth.

Chinese credit growth no longer drives global manufacturing because China is reorienting economic development to domestic technology growth

Chinese credit growth no longer drives global manufacturing because China is reorienting economic development to domestic technology growth

new credit went into spending on computers and communications equipment

Sources: Bloomberg and Wells Fargo Investment Institute, December 13, 2019. Monthly data: May 2012-November 2019. Global manufacturing activity is proxied by 12-month percentage changes in Japanese machine tool orders and the volume of global merchandise trade. The China credit impulse is the 12-month change in total social financing, as a percentage of the 12-month change in economic output (gross domestic product). Total social financing is the sum of all fundraising by Chinese non-state entities, including individuals and non-financial corporate entities. yoy = year over year

Investment implications

We expect further price gains for the British pound, the euro, and European equities and bonds, as sentiment responds to the likelihood of a Brexit deal in January. However, the fundamental outlook for the U.K. and eurozone economies is still mainly driven by a tepid manufacturing recovery and slow growth in China. We view European financial asset prices as indicating relief but also vulnerable to abrupt reversals, while economic fundamentals remain weak. Emerging markets also may see some relief rallies, but it is important to remember that Chinese domestic policies present significant headwinds that are not abating. Therefore, we favor keeping international allocations at their strategic allocations, and we prefer to avoid exposure to local-currency developed market (ex-U.S.) debt.

Overall, we continue to favor a conservative approach to sentiment that could be overextending itself. If our perspectives are correct, Brexit and the trade deals could still be more complicated and uncertain than they appear. We maintain neutral outlooks on most global equity markets (except an unfavorable view on U.S. small-cap equities). If exuberance pushes markets past our targets, we favor taking profits and reallocating temporarily to cash, to await the volatility that should develop as these geopolitical complications return.

Download a PDF version of this report

1 For details, please see our report, Policy, Politics and Portfolios, “Ballooning Borrowing—the U.S. Deficit Challenge”, November 26, 2019, page 4.