Let’s make a deal

Viewers of Let’s Make a Deal, the TV game show of yesteryear, will remember the intrigue
as the two final contestants had to choose among three doors before the set of prizes was
revealed one by one. Occasionally, host Monty Hall would give contestants the option to
change their selection after the first door was opened, furthering the anxiety for contestants
and audience alike. The current trade-war between the U.S. and China is unfolding with
much greater intensity and its outcome, whether positive or negative, will continue to
dictate the path of the global economy and markets in the weeks and months to come. The
13th round of talks is set to take place in Washington during the week of October 7.

Unlike the game show, we already know what’s behind each door. What we don’t know is
which door U.S. and Chinese leaders will agree on: a comprehensive deal, a partial deal, or
no deal. Before exploring each scenario and its likely consequences, a quick contextual
review is warranted to set the scene. Loosening of trade policy has been used historically to
promote mutual prosperity and to reduce social, political, and ideological barriers between
sovereign states. Subject to regular reviews, China was repeatedly granted “most favoured
nation” trade status by every U.S. administration since 1980, and this position was made
permanent in 2000 and paved the way for China to join the World Trade Organization in
2001. As part of its admission to the WTO, China agreed to global trade regulations. With a
burgeoning and low-cost work force, China quickly become the manufacturing hub of the
world. This rise in prominence aided China’s domestic economy (China is now the 2nd largest
economy after the U.S.), while also providing global consumers with cheaper goods and
boosting margins for businesses. Eighteen years after joining the WTO, China runs enormous
trade surpluses with most developed nations (exhibit 1) and is accused of currency
manipulation, theft of intellectual property, and imposing barriers to foreign businesses.
Enter a populist U.S. president with a unique style of diplomacy… the result is a game of
chicken between the world’s two largest economies. Now to what lies behind the three
doors:

Door #1: A comprehensive trade deal is reached

• A comprehensive trade deal would be applauded by global equity markets as it
  could extend an already mature business cycle by encouraging business investment
  and personal spending. Given that equity markets are hovering near all-time highs,
  we think this scenario is partially priced-in. Beyond an initial euphoric reaction, it is
  unlikely that markets will continue to rally given current valuation, late-cycle
  dynamics, and other risks (e.g. U.S. election, Brexit, Iran). Under this scenario,
  further near-term interest rate cuts by the Federal Reserve are unlikely.
• With his approval rating extremely low and re-election at risk, it is crucial for Trump
  that the U.S. economy remain strong going into the November 2020 election. The
  ongoing trade war has already caused fissures in some segments of the U.S.
  economy such as manufacturing and agriculture, which could spread to other
  segments in the absence of a solid deal. A trade deal would reduce further
  economic cracks from developing over the next 12 months.
• China’s autocratic leadership also needs a deal to keep economic growth humming
  and its populace content, and to maintain a tight grip on power. A combination of
  unrelenting protests in Hong Kong with potential economic malaise on the
  mainland from a “no deal” scenario could be a powder keg that Chinese leaders
  would prefer to avoid.
• For a resource- and trade-oriented economy like Canada, this scenario would be a
  positive outcome. A comprehensive deal could also resolve the ongoing issue of
  Chinese technology giant Huawei and the detention of Huawei’s CFO which has
  strained Canadian-Chinese relations since December 2018.
• This is the scenario sought by all, but it remains uncertain how close or distant the
  two sides are in the negotiations. For domestic reasons, both sides want to save
  face by not caving in to the other’s demands and have been ratcheting up tariffs
  and rhetoric after previous talks have faltered.

Door #2: No deal, and the trade war continues

• In addition to big egos on both sides, the issues being negotiated are broad and
  complex and unlikely to be solved completely in the near-term. A successful deal
  would require China to relax well-ingrained policies and move toward a more open
  market system, a direction that is contrary to recent steps taken by China.
• With no re-election to worry about, the current Chinese administration can afford
  to play the long game and potentially negotiate with a new Washington
  administration after the 2020 election. With U.S. economic momentum already
  slowing, a delay tactic by the Chinese could exert further pressure on the U.S.
  economy thereby tilting the balance of power away from incumbent Trump.
• Implications of a no deal scenario and protracted trade war could severely damage
  an already fragile global economic picture, representing material downside risks to
  equity markets.

Door #3: A partial deal is reached, and other issues are kicked down the road

• Recognizing that door #2 could be mutually destructive, we think that both sides
  genuinely want to achieve some progress and claim victory to their respective
  audiences.
• Agreeing on some matters and leaving others unresolved, much like the new North
  American trade deal, we see this as the most likely scenario in the near-term.
• Leaving some issues to fester will encourage businesses to rethink their supply
  chains to avoid being caught in future trade wars between these two economic
  titans.
• Similar to door #1, a de-escalation in the trade dispute would calm financial
  markets but is unlikely to result in a lasting upward move as this is already viewed
  as the most likely scenario.