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Financial markets remain captive to the looming tariff deadline set by President Donald Trump. By the end of the week, investors will know whether the US does raise tariffs on Chinese goods and the likely response from Beijing.

The shifts across global markets so far this week, outside of Chinese equities, have been relatively contained, indicating how investors are resisting panic and sticking to the view that it serves the interests of both Washington and Beijing to reach an agreement after more than a year of negotiations.

In that vein, so long as the US and China continue talking, market sentiment will lean towards optimism of an eventual trade deal. There was a glimmer of this on Wednesday after Wall Street opened and that suggests the market may also look beyond the expected rise in tariffs on Friday. China’s vice-premier Liu He will arrive in Washington on Thursday for an abbreviated round of talks. 

Across equity markets there are varying levels of sensitivity among global benchmarks. China has led the losses with the CSI 300 now back at its mid-March level, indicating how investors think Beijing has more to lose such as jobs and production moving offshore. One point to note is that Chinese equities began falling during the second half of April (call it a healthy correction after their big run) and returned from an extended holiday last week to the news of Tariff Man upping the trade ante.

Hong Kong’s Hang Seng and Europe’s Stoxx 600 have dropped to early-March levels, highlighting that they are next in line for taking a hit from an escalating trade war. On Wall Street, the S&P 500 and Nasdaq have tested areas seen a month ago. The mood on Wall Street suggests many think Mr Trump is bluffing and could well signal a deal awaits after the latest round of negotiations in Washington this week.

Signs of cooler heads prevailing as China and the US continue their trade negotiations would likely spur a rebound in share prices and tighter risk premiums for credit. More importantly from the perspective of emerging markets, the US dollar should ease and government bond yields should rise from near the lower end of their recent range. At this juncture, the Bloomberg Barclays local currency EM debt index has slumped to its early-January level as the JPMorgan EM Currency index has erased its 2019 gains.

In contrast, US equity volatility has not risen much beyond its long-term average reading of 20 this week, although someone is buying insurance against the risk of a bigger jump. Plenty of traders have sold volatility in recent months and option volumes on the CBOE’s Vix are surging, hitting their highest daily amount since February of 2018 on Tuesday according to Credit Suisse, with calls accounting for three-quarters of activity. 

So for now jumping on the fear trade is fraught with risk, but that does not mean markets are immune from a shock as trade talks resume. 

Sebastien Galy at Nordea Investment Funds lays out the challenge for both sides in their trade spat:

“The US would need to back down for China to save face. For that, China would need to reverse its course after backtracking.”

He adds:

“China overplayed its hand recently and may still overplay it again by assuming the Trump administration is afraid of a market correction. What it is after is to get re-elected and that may well mean widening out the tariffs. The question is therefore whether the Chinese will blink because they value short-term growth more than their stature as the other superpower. The next few days may well be quite volatile.”

A danger comes from a breakdown in talks after a prolonged period of false dawns that would open the door towards a genuine bout of risk aversion, primarily led by China and Europe. But global turmoil would ensnare Wall Street’s key sector, technology, along with other US companies that are reliant on global sales as seen late last year when trade tension previously left a mark.

As currency strategists at Bank of America Merrill Lynch point out:

“We have been arguing that trade tensions is a key reason for data weakness outside the US, and particularly in the eurozone and China. The global economy took a sharp turn to the worse when the US introduced the 10% tariff rate on half of imports from China last year. A further escalation from the US and a likely retaliation from China would be a full-blown trade war . . . with very negative implications for the global economy.”

Now BofA’s base case remains one of compromise, but they do acknowledge how the risk of a nasty breakdown is rising, noting:

“In addition, the US-EU trade negotiations have not led to a deal yet and remain a risk for the European economy and markets more broadly.”

So while some observers note the lack of a larger and more damaging rout across markets, particularly in the US, this is hardly a surprising development. Still, the clock is ticking and what heightens the tension for markets is that this year’s already robust performance means steep declines may be required before either side backs down.

Moreover, the prospect of central banks riding to the rescue only appears likely in the event of a dramatic slide that threatens confidence among consumers and business. 

Global equities began May facing a period of sideways trading, reflecting the need for a pause until stronger signs of a resilient economy over the summer would affirm this year’s rally in risk assets. Now the threat of an escalating trade war has returned, competing with the other two big macro issues: whether China stimulus bolsters the global economy and have central banks done enough to support a rebound in activity after their new year policy pivots.

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Quick Hits — What’s on the markets radar

Trade war correlations — UBS show, via this table, the equity markets and sectors that are the most and least sensitive to an escalating trade war.

As the banks notes: 

“Dax has the highest correlation to the performance of trade-impacted stocks, both in absolute terms and relative to regional benchmarks. At the sector level, we have shown that Metals & Mining are most exposed to the performance of those stocks.”

US 10-year note sale — The $27bn issue of 10-year Treasuries was met with lower than usual demand, reflecting the recent drop in yields.

Reasons for upping bond exposure — Here’s Oxford Economics on why moving from cash to core government bonds makes sense, while reducing overweight positions in risk assets.

“As we expected earlier in the year, the relationship between bond and equity returns has turned asymmetric with bonds gaining a lot when equities falter but losing a lot less when equities rally. This makes a core bonds hedge even more attractive.”

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