The markets began to take on a risk-on tone on Friday when the news that American and Chinese negotiators had “made headway on specific issues and the two sides are close to finalizing some sections of the agreement”. Bloomberg went on to report today that the text of the “phase one” agreement is basically done, and the agreement will be signed when Trump meets Xi at the APEC summit in Chile in mid-November:

China said parts of the text for the first phase of a trade deal with the U.S. are “basically completed” as the two sides reached a consensus in areas including standards used by agricultural regulators.

The Saturday comments followed a call Friday with Chinese Vice Premier Liu He, U.S. Trade Representative Robert Lighthizer and Treasury Secretary Steven Mnuchin. The trade negotiators “agreed to properly resolve their core concerns and confirmed that the technical consultations of some of the text agreement were basically completed,” China’s Ministry of Commerce said in a statement on Saturday.

With our trade war factor in roughly neutral territory, we try to answer the following questions:

• What’s on the table in the “phase one” deal?
• What are the prospects for “phase two”?
• What are the market and political implications of such a deal?

What’s on the table?

There are numerous press reports of what has been discussed, and the degree of agreement. Reuters reported that China has offered agricultural purchases that start at the $20bn, which represents pre-trade war levels, and far below the $40-50bn touted by Trump:

Trump has touted purchases of $40-50 billion annually — far above China’s 2017 purchases of $19.5 billion as measured by the American Farm Bureau.

One of the sources briefed on the talks said that China’s offer would start out at around $20 billion in annual purchases, largely restoring the pre-trade-war status quo, but this could rise over time. Purchases also would depend on market conditions and pricing.

In return, Bloomberg reported the US has agreed to suspend the implementation of the tariff increase originally scheduled for October 15, and the mid-December tariffs increase is still up for discussion:

A pause in the tariff escalation, but not an end of them. Trump agreed to forego an Oct. 15 increase to 30% from 25% in the tariffs collected on some $250 billion in imports from China. But the 25% tariffs haven’t gone away. And neither has the 15% tariff on a further $110 billion in goods that took effect Sept. 1, nor the threat that another $160 billion in goods will be hit Dec. 15. There is an expectation the Dec. 15 tariffs, which would hit popular consumer items like smartphones and toys, won’t take effect. But a lot of tariffs remain in place.

CNBC reported that trade czar Peter Navarro has been actively opposed to the deal, but he has little support among American negotiators. Navarro’s objections is a hint of what is not on the negotiating table in “phase one”:

Navarro has taken particular issue with the shelving of certain protections for intellectual property and technology that appeared in earlier versions of the deal, according to these three sources, who are in regular contact with Trump and the administration. Navarro has urged Trump to force China to recommit to previous promises on IP protection or walk away from a deal.

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As announced, the deal would not outlaw China’s subsidizing state-owned enterprises. It would not open China’s economy to all sectors and industries, as the Trump administration had been pushing. And it would not require China to codify the deal into the law — a focal point in talks that became a dealbreaker for Xi in May.

Bloomberg further reported that the Chinese have agreed to concessions on intellectual property and an agreement on currency stability, which may have been enough to placate Navarro:

Concessions on intellectual property. From the beginning, the administration’s big target in its “Section 301” fight against China has been forcing an end to what the U.S. sees as a systematic and state-backed Chinese theft of American intellectual property. Included in the deal being finalized are commitments by China. But they are largely actions China has taken already. It passed new IP and foreign investment laws earlier this year that address the issue. It has also already set up new IP courts to prosecute cases. As always with China, the key is whether authorities enforce the laws.

Currency commitments. As members of the Group of 20 both the U.S. and China have agreed not to manipulate currency markets for economic advantage. Now they will have a bilateral commitment to do so that may lead to the U.S. removing the “currency manipulator” label it slapped on China in August.

What about the all-important agricultural purchases? Here is how much soybeans the Chinese have bought from the US (orange line). That`s right, it`s virtually nothing, and roughly in line with what they bought last year.
 

Moreover, Beijing wants to only commit to buying soybeans based “on market conditions and pricing”. As the following chart shows, Brazilian soybean prices are competitive with US beans, and American farmers will have to compete in the global markets to get China’s business.
 

What about “phase two”?

What about “phase two”? Hu Xijin, the editor of China’s official news organ Global Times, tweeted that a “phase one” deal was likely, but he didn’t hold out much hope of progress for further agreement.
 

If what we have heard so far from news reports is correct, then what is on the table represents an uneasy truce between both sides. China promises to buy $20 bn of agricultural products, which is roughly the pre-trade war level, and it will ramp up to $40-50 bn some time in the future. In return, the US suspends the October 15 tariff increase, and possibly the December 15 increase. Each is trying to retain negotiating leverage, either in the form of more agricultural purchases, or the suspension or rollback of tariffs. This agreement is designed to alleviate the short-term pain felt by each side. The Chinese desperately need more pork imports, and the soybeans needed to feed its pig population. The American side needs to stem the pain felt by its farmers.

Current expectations are the “phase one” agreement will be signed when Trump meets Xi at the APEC summit in mid-November.
 

Market and political impact

If this limited deal were to be signed, what are the market and political impacts? The initial market reaction has been a relief rally, as the risk of further trade war escalation diminishes. Moreover, any suspension of the tariffs scheduled for December 15 removes a threat to US consumer spending, as most of those tariffs would hit consumer goods, and just ahead of Christmas.

Longer term, however, the market and political impacts are less certain.

Former Morgan Stanley Asia chair Stephen Roach derided the deal as nothing more than a smoke and mirrors exercise:

And yet the phase one deal announced with great fanfare is a huge disappointment. For starters, there is no codified agreement or clarity on enforcement. There is only a vague promise to clarify in the coming weeks Chinese intentions to purchase about $40-50 billion worth of US agricultural products, a nod in the direction of a relatively meaningless agreement on currency manipulation, and some hints of initiatives on IP protection and financial-sector liberalization. And for that, the Chinese get a major concession: a second reprieve on a new round of tariffs on exports to the US worth some $250 billion that was initially supposed to take effect on October 1.

Far from a breakthrough, these loose commitments, like comparable earlier promises, offer little of substance. For years, China has long embraced the “fat-wallet” approach when it comes to defusing trade tensions with the US. In the past, that meant boosting imports of American aircraft; today, it means buying more soybeans. Of course, it has an even longer shopping list of US-made products, especially those tied to telecommunications equipment maker Huawei’s technology supply chain.

The broad details of the agreement. (as reported in the press) does not address the bigger underlying questions:

The real problem with the phase one accord is the basic structure of the deal into which it presumably fits. From trade to currency, the approach is the same – prescribing bilateral remedies for multilateral problems. That won’t work. Multilateral problems require solutions aimed at the macroeconomic imbalances on which they rest. That could mean a reciprocal market-opening framework like a bilateral investment treaty or a rebalancing of saving disparities between the two countries that occupy the extremes on the saving spectrum.

Stripped to its core, the “phase one” agreement amounts to $20 bn in Chinese agricultural purchases in return for the suspension of some planned tariff increases. While there is some language about intellectual property protection and currency stability, they amount to nothing more than promises, and their enforcement depend on future Sino-American relations.

If enacted, the “phase one” deal as outlined is likely to only formalize a ceasefire in the trade war, and does not represent any substantive progress. Even if the deal were to be concluded with only planned tariff suspensions, and no tariff rollbacks, Trump is likely to attract criticism from both sides of the aisle in Washington. This will not help his standing in light of his political position when he is under impeachment pressure. He will need members of his own party to support him, and what amounts to a cave at the negotiation table is not helpful for Republican support.

Bottom line: The good news is both sides are talking, and the chances of further escalation in the trade war is receding. If I am correct in my assessment of a global cyclical upturn (see An upcoming seismic shift in factor returns), then the market’s expectations of trade war risk should also fade over time. The bad news is that the Sino-American trade, strategic, and diplomatic relationship has been permanently damaged. We are unlikely to see any trade peace, regardless of who wins the White House in 2020.

Disclosure: Long SPXL
 

Our trade war factor has been heating up, though readings remain in neutral. A secondary index (red line) measures Sheldon Adelson’s Macau casinos operator LVS against other gaming stocks (inverted). As Adelson is a major Republican donor, and the casino licenses expire in 2022, the licenses represent another form of backdoor pressure that Beijing can apply to trade relations.
 

Chinese and American negotiators are scheduled to meet again on Thursday, October 10 for another round of trade negotiations. There have been conciliatory gestures on both sides, but what are the chances of a deal?
 

What does Trump really want?

It is difficult to see how a comprehensive deal could be agreed on, as it is highly unclear what Trump really wants. On one hand, the transactional Trump is focused on narrowing or eliminating the trade deficit by bring back manufacturing back to American shores. On the other hand, Navarro has long complained about China’s business practices and industrial strategy of favoring domestic and state owned companies, intellectual property theft, and the ability of foreign companies to operate in China.

Imagine if we were to wave a magic wand and Navarro got all of his wish list. China’s economic access restrictions disappears, and the economy becomes fully westernized. It would encourage an offshoring stampede in light of their cheap labor costs. The trade deficit would rise, not fall.

What does Donald Trump really want?

A technological iron curtain?
In addition, Hal Brands wrote a Bloomberg opinion piece that US trade practices are affecting western leading countries in Asia. He cited Singapore as an example. Singapore is officially neutral, but it is “a partner that acts like an ally”:

Singapore has pulled off a shrewd balancing act in a contentious neighborhood. Singapore’s dynamic economy has been buoyed by Chinese trade and investment, and its population is mostly ethnic Chinese. Yet getting too close to a powerful China can be dangerous, so Singapore’s government has long viewed Washington as a critical counterweight to Beijing’s power. As that power has increased in recent decades, so has Singapore’s security cooperation with the U.S.

Singapore’s armed forces regularly train with (and in) the U.S., and Singapore hosts the U.S. Navy’s Logistics Group Western Pacific as well as deployments of littoral combat ships and P-8 maritime surveillance planes. U.S. aircraft carriers conduct port visits in Singapore, a visible reminder that Washington takes an interest in the country’s security. Singapore remains officially neutral; unlike the Philippines, it does not have a treaty relationship with the U.S. Yet if the Philippines is an ally that acts like a partner, as a senior U.S. official once put it, Singapore is a partner that acts like an ally.

If Trump were to continue on the current course of action that decouples China’s economy from the rest of the world, America’s partners and allies will have to choose sides.

The trend toward seeing the U.S.-China competition as “a conflict between two systems, almost two civilizations” is “very worrying,” he said. The U.S. should not delude itself into thinking that pressure can bring about the collapse of the Chinese Communist Party; it should bear in mind that an economic and technological divorce between the world’s leading powers would create an impossible situation for America’s friends “so deeply enmeshed with the Chinese.” If the U.S. insists that these countries choose sides, it might not like the results: “Where is your part of the world, and who will be in your system?”

At the same time, Lee acknowledged that China’s behavior has become more truculent, due to rising geopolitical ambitions and growing internal difficulties. He also argued that China can no longer act like a developing country, but must bear its “share of responsibility upholding and supporting the global system” that has made it so rich and powerful. If a disastrous geopolitical showdown is to be averted, “statesmanship, consistency, perseverance and wisdom” will be required from both sides.

The prospect of a “technological iron curtain” coming down in the Pacific will have devastating effects on growth, not just in the US, but for the Asia-Pacific region.

A larger confrontation with China will be economically painful for U.S. — but it could be economically devastating for America’s key allies and partners in the Asia-Pacific, all of which are deeply interdependent with Beijing in commercial, financial and technological terms. The prospect of a technological or economic Iron Curtain coming down is alarming for countries whose economic interests pull one way while their security interests pull another. To be sure, the U.S. can’t compete successfully with China unless its friends become less dependent on Beijing: Some selective de-coupling from the Chinese economy is important, even if wholesale de-coupling remains implausible. Yet the only way to get countries such as Singapore to reduce their dependence on Beijing is to vastly deepen the possibilities for economic, financial and technological integration within the U.S.-led coalition. Here, America presently seems like an uncertain partner, at best.

Here is one example of just one incident of how tensions have hurt American businesses. Houston Rockets GM Daryl Morey recently tweeted support for the protesters in Hong Kong.
 

In response, China cut off all cooperation with the Rockets. This was an enormous blow to the team, as the Rockets was the second most popular team in China behind the Warriors. Hall of Famer Yao Ming played for the Rockets and popularized basketball in China. Tencent, the NBA digital rights holder in China, blacked out the broadcast of all Houston Rocket games. As a measure of the importance of China to the league, an NBA press release in July had announced a five-year expansion of the Tencent-NBA partnership that is worth $1.5 billion, and reported that 490 million Chinese fans, which is more than the size of the US population, watches NBA games on the Tencent platform.

The NBA issued the following statement as a way of trying to repair the situation. Regardless of whether you support or oppose the NBA’s position, remember the league’s business is making money, and not politics, so it is understandable that it took the steps it did to mitigate the damage.

“We recognize that the views expressed by Houston Rockets General Manager Daryl Morey have deeply offended many of our friends and fans in China, which is regrettable. While Daryl has made it clear that his tweet does not represent the Rockets or the NBA, the values of the league support individuals’ educating themselves and sharing their views on matters important to them. We have great respect for the history and culture of China and hope that sports and the NBA can be used as a unifying force to bridge cultural divides and bring people together.”

As another example of forcing allies and partners to choose sides, Bloomberg reported that Chinese students are increasingly avoiding American schools, and they are looking elsewhere. At at minimum, expect America’s current account with China, which measures services as well as goods, to fall.

“There is a shift,” says Jerry He, executive vice chairman of Bright Scholar Education Holdings Ltd., based in the southern Chinese city of Foshan. Bright Scholar in the past year has purchased more than a dozen boarding and language schools, with U.K. campuses in Cambridge, Canterbury, and London. “With the tensions between the two countries, things that have happened in the news made some Chinese parents hesitant, and they have had second thoughts about where they will send their kids.”

The number of Chinese undergraduates accepted to British schools increased 10.4% last year, to 10,180, according to the Universities and Colleges Admissions Service, a nonprofit that works with almost 400 schools in the U.K. The number of Chinese students applying jumped 30%, to more than 19,700.

Much is at stake for U.S. institutions, many of which have welcomed the influx of Chinese students, who typically pay full tuition. Chinese students in the U.S. generated $22 billion in total economic impact last year, according to Rahul Choudaha, executive vice president of global engagement and research at Studyportals, a consulting firm headquartered in the Netherlands.The realignment will undoubtedly crash Asian growth rates and cause a regional recession. Without knowing the actual timing, and effects, it is impossible to forecast whether it could also cause a US recession as well.

Is this what Donald Trump wants?
 

A mini-deal?

The Chinese have very likely to interpret recent events as weakening Trump’s political position, which will harden their negotiating position and makes it unlikely for them to give much in the way of concessions. They will see the combination of the House’s impeachment investigation, and Trump’s recent public call for China to investigate the Bidens of his deteriorating clout.

In addition, October 10, the date of the negotiation, holds a special meaning in Chinese history. It was the date of the Sun Yet-sen’s uprising that ultimately toppled China from imperial rule. While the anniversary is more observed in Taiwan than Mainland China, it nevertheless.represents a key date in Chinese history, and negotiators are unlikely to concede much on a historic date like that.

Bloomberg reported that Chinese negotiators are preparing to come to the table with a mini-deal:

Chinese officials are signaling they’re increasingly reluctant to agree to a broad trade deal pursued by President Donald Trump, ahead of negotiations this week that have raised hopes of a potential truce.

In meetings with U.S. visitors to Beijing in recent weeks, senior Chinese officials have indicated the range of topics they’re willing to discuss has narrowed considerably, according to people familiar with the discussions.

Vice Premier Liu He, who will lead the Chinese contingent in high-level talks that begin Thursday, told visiting dignitaries he would bring an offer to Washington that won’t include commitments on reforming Chinese industrial policy or the government subsidies that have been the target of longstanding U.S. complaints, one of the people said.

That offer would take one of the Trump administration’s core demands off the table. It’s emblematic of what analysts see as China’s strengthening hand as the Trump administration faces an impeachment crisis — which has recently drawn in China — and a slowing economy blamed by businesses on the disruption caused by the president’s trade wars.

Will Trump accept a mini-deal? He is on record as only entertaining an all encompassing deal, but he has been known to change his mind in the past.

However, consider the following political calculation. Trump’s attacks have weakened Joe Biden, who has been the front runner for the Democrat’s nomination for president. As well, Bernie Sanders’ medical difficulties have also lessened his chances for securing the nomination. This leaves Elizabeth Warren a clear shot at becoming Trump’s opponent in 2020. Warren has outlined her own brand of economic nationalism (see What would an Elizabeth Warren Presidency look like?), and she would shred Trump with his supporters if he were to conclude any weak mini-deal with Beijing.
 

In conclusion, expect platitudes, and some possible signals of progress. At best, the scheduled increases in US tariffs will be delayed. Don’t expect any breakthroughs. Trump is too boxed in to make a deal with Xi.