Given the assumption that the observed datapoints are normally distributed, barometer readings can be seen as the market-implied probability for a “trade deal” if one believes the historical highs (Jan 19) or lows (Mar 18) over the past 18 months are in fact reasonable representations of those outcomes. Using this logic, the market is currently discounting around a 20% chance that a trade resolution could be reached by the two sides, versus close to 80% in late April. Once again, the barometer only focuses on the market-implied probability/expectation of a trade resolution, and the nature/feature of a “deal” is out of the scope of this analysis.
As the barometer appears fairly correlated with the aggregate index P/E, one can also deduce the expected market P/E under a “trade deal”/”no trade deal” scenario based on simple regression analysis. In a nutshell, the model shows thatMXCN should trade at around 11.5x forward P/E under Goldman’s China base-case growth (6.4% GDP), FX (USDCNY @ 6.95), and US monetary policy assumptions (US FCI ex Equity @100.2), but “trade”, as a standalone factor, could drive index PE to 13.5x and 10.5x in a “trade deal” and “no trade deal” situation, respectively. This is largely consistent with the suggested results from the barometer that the market is factoring in a fairly slim chance for a “trade deal” to materialize at the moment.
Overall, this exercise lends support to Goldman’s China Overweight call, which is predicated on China’s domestic policy flexibility (to counteract external challenges), stabilizing earnings momentum, inexpensive valuations with the trade concerns looking fairly priced (vs. our economists’ base case), and compelling investor positioning upside optionality in light of decade-low allocations in H shares and continued portfolio inflows to A shares due to index inclusions. That said, under a prolonged “no deal” scenario where we would expect the unfavorable trade impacts to percolate to other parts of the economy, we see potentially a 13% cut to corporate earnings growth by 2020 and as much as 20 % price return downside from here, with PEs comparable to their troughs in Oct 2018.
More:
Chinese exporters to the US: While the US accounts for only 1% of total revenues for MSCI China index constituents, the US market is a significant export destination for select Chinese companies, predominately concentrated in Tech Hardware, Consumer Discretionary and Industrials. As such, Goldman focuses on their relative price returns and valuation gaps versus the benchmark to better understand how the trade tensions have been discounted in the equity market.
US companies with high China revenue exposures: Similarly, US equities are largely domestic-oriented from a revenue contribution standpoint but China is an important source of end-demand for a number of US consumer and tech companies, with China representing 17% of the top-line for the top-40 US firms in the S&P500 with the highest Greater China exposures. The bank focuses on these companies’ relative returns and P/E disparity relative to S&P500 to isolate the “trade factor” in their pricing regime.
Asian suppliers to the US/China: The impacts and concerns of trade frictions have so far been most visible (and aggressively priced) in direct exporters in the US and China, but Asian companies along the tech and consumer goods supply chains outside of the two markets will likely see disruptions given how intertwined the global supply chain has become over time. As such, the bank adds the relative returns and valuation series for a list of Asian tech and consumer companies (ex. China) with high US sales linkages and significant production exposures from China to the sample universe.
Rmb depreciation winners vs losers: While many macro and policy factors could move the Rmb, its seems that “trade” has been one of the most influential components in the Rmb pricing equation over the past 18 months. Therefore, the bank refers to its Rmb depreciation winners and losers baskets (performance and PE gaps) to gauge the potential FX/trade impacts on equities.
The bottom line: while the market seems to have discounted a fairly bearish trade negotiation outlook in equity prices, individual investors may have different views towards the trade development. As such, for the purpose of trading the “trade risk” for investors who embrace strong and active views on this particular subject, Goldman screens for Chinese stocks (and MSCI China index constituents) that have exhibited strong positive (i.e. trade tension losers) and negative (i.e. trade tension winners) relationships with the bank’s trade barometer in Exhibits 14 and 15 – their relative returns have tracked the barometer and the tariffs imposition time series well.
My own view is that prospects are still falling. With the Fed at Trump’s back he can now string markets along for ages. Each times they fall the Fed will cut and Trump talk up a deal, lifting his favourite economic index: stocks. The longer it takes the better now as each passing month sees China exit the global economy just that little more.
It’s all down to China buckling now and that does not seem likely, rather stupidly.
David Llewellyn-Smith is Chief Strategist at the MB Fund and MB Super. David is the founding publisher and editor of MacroBusiness and was the founding publisher and global economy editor of The Diplomat, the Asia Pacific’s leading geo-politics and economics portal.
He is also a former gold trader and economic commentator at The Sydney Morning Herald, The Age, the ABC and Business Spectator. He is the co-author of The Great Crash of 2008 with Ross Garnaut and was the editor of the second Garnaut Climate Change Review.
