Why The Market Misunderstands Trump’s Asian Diplomacy

Christopher Smart, Head of Macroeconomic & Geopolitical Research, discusses why conventional wisdom relative to U.S. relationships in Asia may be backwards.

The end of February brought a banner week for Asian diplomacy with a tariff truce coming into view and a small step backwards in Korean nuclear negotiations. Markets greeted developing Chinese negotiations warmly, yet barely reacted as the Trump-Kim summit was cut short in Hanoi. The conventional wisdom is that the China relationship is headed for better days, while process on defusing the Korean threat has stalled.

In reality, the logic may be entirely backwards.

We pause here to mention in passing another escalating Asian crisis now brewing between India and Pakistan, but since both the Karachi and Mumbai markets seem to be taking it in stride we will leave this one with the diplomats.

“If the China deal looks anything like what has leaked so far, it is a warmed-over set of commitments that China has failed to deliver for years.”

If the China deal looks anything like what has leaked so far, it is a warmed-over set of commitments that China has failed to deliver for years. In Korea, on the other hand, Trump has already set off a process that will likely transform Asia for decades.

On China, perhaps, the market has been reacting mostly to the prospect that U.S. tariffs on $200 billion in Chinese imports will be frozen or repealed given the warm words President Trump had for President Xi Jinping and the announcement of a likely meeting at Mar-a-Lago.

Both sides look eager for a deal. While China’s recent economic slowdown has been driven mainly by its own efforts to rein in shadow banking activity, the standoff with Washington hurt consumer sentiment, which aggravated the slowdown. The continuing tension remains a focus of US markets, and American farmers have been hit hard by a decelerating Chinese purchases.

CHINA RETAIL SALES (Y/Y)

SOURCE: FACTSET, AS OF DECEMBER 31, 2018

U.S. GOODS EXPORTS TO CHINA

SOURCE: FACTSET, AS OF DECEMBER 31, 2018

We won’t likely know the precise terms of any agreement until the two leaders actually meet. U.S. Trade Representative Robert Lighthizer already offered a few hints in testimony last week and it all seems more incremental than transformative.

• China has reportedly agreed to buy more soybeans, rice and wine, but the real test will be if it’s much more than it would have bought anyway given its expected economic growth in the coming years
• A commitment to currency ‘stability’ will reportedly be part of the deal, apparently addressing longtime charges of ‘manipulation.’ But for the last five years, Chinese authorities have been mainly intervening to lean against sharp market moves. It will take a keen eye to identify the ways ‘stability’ is defined in the agreement and how that differs from what the Chinese are already doing.
• Government subsidies have been a persistent complaint among international firms competing against Chinese rivals. Chinese authorities have reportedly chosen to soft-pedal their “Made in China 2025” program to secure leadership in key global industries, from aviation to robotics. But is it really plausible that China will abandon efforts to promote Chinese champions across the global economy?

The economic friction between Washington and Beijing are structural and unlikely to be fully addressed in any single agreement. We may be surprised when the details are released, but so far this truce looks more convenient than substantive. It’s hard to believe that fresh economic hostilities—and fresh tariffs— won’t break out sooner or later.

Meanwhile, in Hanoi, President Trump and Chairman Kim Jong Un cut short their meeting after a reasonably warm exchange before the assembled press. The president said he needs more North Korean commitments to the denuclearization process before he considers loosening economic sanctions, and there were concerns that the process might collapse.

But these fears miss the point: dramatic geopolitical shifts in Asia are already underway. Even two famously unpredictable leaders will find it difficult to reverse the process that they themselves have triggered.

We are at a rare moment in which the interests of all the key players are aligned:

• A North Korean leader who believes he can leverage his country’s nuclear capacity for economic concessions
• An American president who not only wants a deal, but can also probably deliver a deal without excessive static from security hawks in his party
• A South Korean leader whose entire career has targeted relaxed tensions with the North
• Chinese and Russian leaders who are crossing their fingers for a deal that would undercut U.S. justification for keeping 23,000 troops on the Korean peninsula

As long as this rare alignment lasts, there will be a slow, but steady warming of relations. In spite of the president’s hard line this week, more inspections of North Korea’s nuclear sites may ultimately yield fewer economic sanctions. We may never arrive at complete denuclearization, but we are also unlikely to revert to provocative missile tests and name-calling.

This means these Trump-Kim meetings are triggering change of historic proportions: an unprecedented thaw on the Korean peninsula, an irreversible ebb in the U.S. military presence there and an unpredictable realignment of alliances.

• Less U.S. engagement in the region may encourage Japan to boost its own military
• Russia may see an opportunity to accelerate a normalization with Japan
• South Korea may resist reunification to avoid the huge cost of rebuilding the North, but may not ultimately have a choice if economic reforms in Pyongyang undermine the regime itself
• China may find expansive new opportunities open up as it seeks to shape the region

Naturally, it’s much easier for markets to price in an end of U.S. and Chinese tariffs than something so much more consequential and unpredictable. But the region’s long-term investors should make no mistake that something transformative is afoot.

And they should keep an eye on the news from New Delhi and Karachi, too.

PAKISTAN KSE 100

SOURCE: FACTSET, AS OF FEBRUARY 28, 2019

INDIA BSE SENSEX

SOURCE: FACTSET, AS OF FEBRUARY 28, 2019