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Institute Alert: Good News on Trade Doesn’t Go Very Far

Wells Fargo Investment Institute - July 1, 2019

Key takeaways

  • Last weekend in Japan, the U.S. and China agreed to restart their trade negotiations. The truce was expected, but formidable obstacles lie on the road to a deal.
  • We believe a partial trade deal in 2020 seems to be the most likely scenario, but investors should expect more periods like the past six weeks and the attendant market volatility.

What it may mean for investors

  • We continue to favor portfolio rebalancing, a selective approach to global regional markets, sector rotation, and an emphasis on quality.

At a global summit last weekend, the U.S. and China agreed to restart their trade negotiations. President Trump agreed to remove some curbs that block a large, Chinese telecom company from buying high-tech U.S. components. The U.S. also will delay indefinitely a new round of tariffs that could have hurt the global economy more than the tariffs now in place. Chinese President Xi conceded to buy more U.S. products. In fact, last Friday, the U.S. Department of Agriculture reported a sizable Chinese order for 554,000 tons of U.S. soybeans.

Our perspective

We expected this truce, and equity markets probably have priced in much of the outcome. Looking ahead, the two sides still disagree on the same issues that stalled the talks last month. Beijing wants the U.S. tariffs to be removed and needs unfettered access to U.S. technology. The U.S. wants tariffs in place to enforce Chinese compliance with an eventual deal, however, and is unlikely to allow China access to technology that could control U.S. wireless networks. The U.S. also wants China to buy large quantities of U.S. energy and agricultural products, but China has countered that it will only buy what it needs—which is likely to be much less than President Trump would like to see. Above all, it is difficult to avoid the conclusion that China and the U.S. have arrived at a strategic competition—particularly in technology—that may overshadow and complicate relations from trade to national security, possibly for decades to come.

Consequently, our view since May anticipates three possible scenarios.1 The most likely is a partial deal by sometime in 2020. We expect both sides to play a long game.

President Xi may want to see if President Trump can win his 2020 election, while President Trump probably wants a deal close enough to November 2020 to bolster his popularity with voters. In addition, any deal is likely to be partial—that is, one that keeps some of the tariffs and other restrictions. The two sides already have shown themselves ready to withdraw prior concessions for leverage on the more difficult issues. Fits and starts in the talks are very likely and should generate more global market volatility.

Two other outcomes seem much less likely. A deal before the end of 2019 could happen, if U.S. and Chinese intransigence weakens the two economies. Fortunately for investors, neither economy appears to face an imminent recession. Another unlikely scenario is a complete breakdown in talks. Both leaders would strongly want to avoid this outcome, which could advance the next economic recession and leave the leaders politically vulnerable.

We favor a three-fold strategy

If our base case develops, pullbacks in global equity and fixed-income markets may result. Modest consumer spending globally should sustain positive economic and earnings growth, especially in emerging markets, where local spending is strong. Yet, the bulk of the financial-market returns seem built on avoiding a 2019 recession and, more recently, on expectations of Federal Reserve (Fed) interest-rate cuts. Such expectations can make bonds look expensive and stocks comparatively cheap. But U.S. and European central bankers may find their monetary stimulus disappointingly ineffective, while contracting global trade weakens business spending on equipment.

We favor portfolio rebalancing, regional selectivity, and sector rotation:

  1. Regarding world regions, we favor the emerging equity markets. Their trade-related sectors (Information Technology and Industrials) have suffered from the trade disputes, but their local consumer-oriented sectors (Financials, Health Care, Consumer Staples, and Consumer Discretionary) are generating strong earnings growth.
  2. In U.S. equity and fixed-income markets, we favor trimming positions toward long-term target allocations should U.S. markets overshoot our year-end target ranges (2800-2900 for the S&P 500 Index and 2.00%-2.50% for the 10-year Treasury note). We also favor taking opportunities on pullbacks to allocate cash in equity and investment-grade fixed income assets.
  3. We see a potential opportunity to rotate among sectors. Expectations for Fed interest-rate cuts have fueled a bid for income in Utilities, real estate investment trusts (REITs), and high-yield debt (including high-yield corporate and high-yield municipal securities). With interest rates at the lower end of our 10-year Treasury yield target range for year-end, we see a potential opportunity to rotate into cyclical sectors that should benefit from continued economic growth—including Information Technology, Industrials, Consumer Discretionary, and Energy. Interestingly, we find that these sectors are the most attractive for their cash-to-debt ratios, a measure of quality that we prefer amid the large buildup in corporate debt during this cycle.
 
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1 Our detailed expectations for U.S.-China trade talks appear in our report, “He Said, Xi Said: Can There Be a U.S.-China Trade Deal?”, May 28, 2019.