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Trade deal unlikely to provide more upside for equities, says Capital Economics

Optimism about trade has been a factor behind the rally in global equities in the past month. But with a “mini-deal” now largely discounted in the markets, and economic growth unlikely to do better than stagnate over the next couple of years, any further upside for stock prices is likely to be limited, according to the latest research report from Capital Economics.

It can be hard to pin down what investors expect when it comes to the trade war. But a starting point is to look at the absolute and relative performance of the equity markets most exposed to rising protectionism since the US and China agreed a deal in principle on October 11.

Since then, MSCI’s ACWI index of large and mid-cap stocks across 23 developed and 26 emerging markets has risen by 5.5 percent. But the equities of countries most exposed to the trade war have generally rallied by more.

The MSCI China Index has been a notable exception, rising by only 4 percent during this period. But this has much to do with the ongoing protests in Hong Kong as well as concerns about China’s economy more generally. Indeed, MSCI’s index of China’s onshore equities has actually fallen by 0.5 percent.

There is more evidence in the sector data of easing trade tensions having had a positive effect. Sectors most vulnerable to the trade war have outperformed by 4-6 percentage points since October 11.

And the ratio of the semiconductors sub-sector to the MSCI ACWI Index is now well above its level in early-April 2018, when President Trump first threatened tariffs on USD50 billion of Chinese imports.

Admittedly, other factors may well have contributed to the strong performance of those sectors, for example a shift in the electronics inventory cycle (for semiconductors) and new emission legislation (for autos). But it still suggests that there is not much scope for equity prices to receive a further boost from a deal along the lines being reported.

The risks from here lie to the downside, for a few reasons. For a start, the latest media reports (and Trump’s equivocal comments) cast doubts on whether a “mini-deal” will even be reached. After all, previous truces at the G20 in late-2018 and in the spring of 2019 amounted to nothing, the report added.

What’s more, even if a “mini-deal” were finalised, it would only undo a small fraction of the tariffs so far imposed. The most likely scenario is that the average US tariff on imports from China is reduced to around 19 percent, which is substantially more than the 3 percent levied prior to the trade war.

Of course, US/China relations are not the only determinant of equity prices. Indeed, the strong performance of global equities of the past month or so partly reflects optimism about the world economy more generally.

"But although the economic data have held up better than anticipated recently, they are still lacklustre, and we think that they will deteriorate further in the next couple of quarters and remain weak thereafter," Capital Economics further commented in the report.

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