In his lead article from EM Watch of 28 May, Jon Harrison argues that neither trade nor tech risk are still correctly priced in despite the chaos of the US-China trade negotiations.
This stage of the trade war is characterised by threat and counter-threat. The US and China remain open to further talks but the acrimonious atmosphere created by US escalation and harsher rhetoric on both sides means that the resumption of relatively friendly negotiations is off the table for at least the next month. The prospect of a Trump-Xi meeting in Osaka at the end of June offers the chance to resume talks.
A less bad scenario for emerging markets remains possible. A new round of talks would calm markets and likely put on hold further escalation of tariff and technology measures providing a window of perhaps 3-6 months during which compromise on both sides could facilitate a deal. Negative developments in the economy and markets will help to align incentives. A return to negotiations in the next few months is our core scenario. Even in this best case, however, there is likely to be further downside for EM, not least because the severity of potential downside risks to EM is increasing. There is a growing probability that relations break down leading to a longer period of disengagement and inevitably deeper damage to the world economy. Such an outcome becomes more probable if Trump and Xi do not meet in June.
Investor sentiment is the first casualty. Threatening rhetoric is likely to intensify as both sides aim to demonstrate the strength of their potential economic leverage and their preparedness for a protracted struggle. This is almost certain to be detrimental emerging market investor sentiment even if the actual economic damage of broader escalation into exports of key US technology so far remains limited. The impending application of 25% tariffs on $200bn of imports from China due to arrive at US ports in the coming weeks will, however, have a direct negative impact on world trade and US economic data in the coming months. Indeed, the worse than expected decline in US manufacturing PMI last week confirms that the escalation of the trade war since Trump’s 5 May tweet is already having a negative impact on businesses.
Contracting EM exports are already baked-in but not yet priced in.
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