US, China trade smileys – Equity risk premium now takes a back seat

For Indian equities, export-oriented sectors with exposure to the US in particular should gain because of continuation of elevated import tariffs between the two largest economies for a major chunk of goods. Sectors such as metals, chemicals and pharma can capitalise on the import substitution opportunity in the US. Hence, investors can position themselves accordingly.

US trade deficit with China to reduce

A big takeaway from the Phase 1 deal is commitment of China to purchase an additional $200 billion worth of US goods and services over the next two years. What are the implications? This would lead to more than 50 percent increase in US exports to China on an annual basis.

China’s increased imports of US goods and services are expected to continue on this same trajectory for several years after 2021 and should contribute significantly to the rebalancing of the bilateral trade relationship. According to Reuters, $200 billion worth of additional exports to China would consist of $80 billion of manufactured goods, $50 billion of energy supplies, $30 billion of agriculture products and $35 billion of services. This can significantly reduce the overall trade and services deficit of the US versus the rest of the world from the level of $628 billion in 2018.

Table: US Trade in Goods and Services

Source: www.census.gov

What’s more?

There has been some progress on contentious issues, including technology transfer and intellectual property rights (IPR). China has agreed to end its long-standing practice of forcing or pressuring foreign companies to transfer their technology to Chinese firms in lieu of market access.

To sweeten the deal, the US has removed China’s designation as a currency manipulator in its semi-annual currency report. The US Treasury now says China has committed to refraining from competitive devaluation as part of the Phase 1 trade deal.

Sceptics are worried still

China’s pledge shows a likely sharp jump in its imports from the US in times to come. But that’s easier said than done. The big question is, how does China go about the execution part, which may substantially reset its trade ties with other key partners. Second, its agreement and enforcement on prickly issues remains a key factor to watch.

Coming to the US side, there is no major rollback in trade tariffs. As a rider, the US has agreed to shelve tariffs on another $160 billion of Chinese goods which were scheduled to take effect from December 15, 2019. Additionally, it has reduced by half the 15 percent tariff it imposed on $120 billion of Chinese goods on September 1 last year.

So, in totality, the US retains higher tariff on imports worth of $370 billion from China. This includes duty of 25 percent on $250 billion Chinese goods and 7.5 percent for the remainder $120 billion. Average tariffs on both sides are in the vicinity of 20 percent, a far cry from the pre-June 2018 level.

Chart: US-China trade tariffs (average rate)

Source: Peterson Institute of International Economics

Much of the additional tariffs appear to be a new normal for both for the near term. News reports suggest that any reduction in tariff may be considered in Phase 2 of trade negotiations, which may conclude after the US presidential elections in November 2020.

Takeaways

To be sure, the trade pact has eased the woes for global stocks and substantially reduces the risk premium. In the past, various international agencies have termed the trade war as a drag on global growth and saw it as a prime reason for the resultant uncertainty. We believe that the current round of US-China bonhomie, along with the clarity on Brexit deadline after the UK election, has lifted that cloud of trade uncertainty for 2020.

At the same time, a good part of higher import tariffs would continue to remain on both sides. That means there is an opportunity for other countries to benefit from trade diversions. According to a UNCTAD (United Nations Conference on Trade and Development) report, Taiwan, Vietnam, Mexico, Korea and India are among the key beneficiaries from the trading spat as importers in the US and China turned to import substitution from these countries. India particularly has benefited from higher exports to the US for chemicals, metals and precision instruments.

Table: Trade diversion benefit for countries/sectors in H1 of 2019

Source: Trade and trade diversion effects of United States tariffs on China, UNCTAD – November 2019

It’s also a matter of interest to track sectors or companies from global cyclicals such as pharma APIs (active pharmaceutical ingredients) and chemicals that eye gains from the ongoing trade dynamics. A policy push for job creation and renewed thrust for Make in India will definitely be an icing on the cake.

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Disclaimer: Moneycontrol Research analysts do not hold positions in the companies discussed here