The month of October is historically tricky for markets but investors holding their breaths can soon exhale as valuations of risk assets have mostly been supported by a trio of factors.
First, the announcement of a preliminary US-China “first phase” trade deal and the suspension of an increase of US tariffs from 25% to 30% on US$250b on Chinese goods that was planned for 15 October.
Second, positive developments relating to Brexit where the UK parliament for the first time voted in a majority supporting a Brexit deal, albeit with an amendment that prevents Prime Minister Boris Johnson from pushing for an exit before 31 October.
Third, an encouraging start to the 3Q earnings season. About 30% of the S&P 500 have reported results to date and 81% of company earnings have come in above consensus, versus a historical average of 68% beats since 2004.
Markets look likely to remain supported over the near term, especially if we also consider our base case that the Fed will, at its end-October meeting, cut rates by 25 bp while communicating a “wait-and-see” stance henceforth with an open mind to act further if warranted.
Over the longer term, these latest developments point to tail risks being trimmed at the margin, although significant uncertainties relating to US-centric trade policy and geopolitical risks in Western Europe persist in the backdrop - particularly as the negative impact of previous rounds of tariffs continue to work through the global economy.
On trade, the broad strokes of the “first phase” US-China agreement are that the Chinese would buy agricultural goods in exchange for the White House suspending the tariff hikes planned for 15 October. We see better-than-even odds of this limited deal being eventually ratified, considering that these concessions are low-hanging fruits that both sides can agree on.
We also see better-than-even odds that the US tariffs planned for 15 December will be suspended. With the US economy by now clearly hit by previous tariffs and an impending 2020 re-election campaign, the White House will be keen to avoid additional economic damage from the 15 December tariffs.
One issue is that it would be a stretch for the Chinese to purchase the indicated amount of US$40b to US$50b of agricultural goods in a single year. Total Chinese purchases of US farm goods in 2017 amounted to US$24b – about half of the amount cited.
Another issue is that China has reportedly asked for another round of talks before finalizing the agreement at the APEC summit in mid-November – which is just a few weeks away – and no such meetings have yet been scheduled.
However, these issues need not be deal-breakers if both sides are motivated to reach a mutually beneficial agreement.
Of course, the risk of a breakdown in trade talks is ever present, and one needs to ask if a truce can last or if the impact of trade uncertainty on business sentiment would ease meaningfully. This is the third attempt at a lasting US-China trade truce, having already failed twice before, and there is much mutual distrust fomented by the discord over Huawei and US involvement in Hong Kong’s protests.
On Brexit, the spectrum of potential outcomes has shifted towards a positive direction. For the first time since Theresa May’s abortive attempts, the UK Prime Minister has a Brexit deal on his hands that likely has enough support to win a straight up-or-down vote.
While there are multiple permutations of scenarios ahead – which could include early elections, a no-confidence motion, a referendum, or PM Johnson pushing through his Brexit deal through regular order during the three-month extension – what is key for markets is that the risk of a no-deal Brexit on 31 October is greatly reduced.
While no-deal risk could well resurface in 2020, multiple roads from our scenario analysis at the time of writing appear to lead to some version of soft Brexit similar to Johnson’s deal or a referendum that might lead to no Brexit at all.
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