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Markets Rally on Phase One Trade Deal Signing

January 20, 2020
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Monday Morning QB - Market Observations:

  • “Phase One” Trade Deal with China Officially Completed
  • U.S.-Mexico-Canada (USMCA) Trade Agreement Signed into Law
  • Stock Market Momentum Continues
  • Major Banks Kick Off Earnings Season with Solid Gains
  • December Housing Starts at Best Level Since 2006
  • U.S. Consumer Starting the Year Strong Based on Solid Retail Sales Reports and Continuing Low Unemployment Claims

Monday Morning QB - Market Performance:

Most major U.S. indexes hit record highs again this week as investors welcomed the signing of the “Phase One” trade deal between the U.S. and China.

Small caps led the way with the Russell 2000 rebounding 2.5% after three weeks of declines. The Dow Jones Industrial Average added over 524 points lifting the index above the 29,000-level, closing at 29,348—a gain of 1.8%.

The technology-heavy NASDAQ Composite rose for a seventh consecutive week, adding 2.3%, while the large cap S&P 500 added 2.0%. The S&P 400 midcap index rose 2.2%.

Beijing and Washington sign a "Phase One" Trade Deal (A Cease Fire)

Trade tensions between the U.S. and China cooled off somewhat this week as the “Phase One" trade deal was signed in a ceremony in Washington on Wednesday.

The U.S. agreed to suspend tariff increases as well as cut the rate on some of the current tariffs.

Tariffs will remain on about $370 Billion of Chinese goods. The remaining tariffs will be bargaining chips in the next round of negotiations. President Trump said, “The remaining tariffs will all come off if the talks produce a second agreement.”

The Chinese agreed to the purchase of approximately an additional $200 Billion of American-produced goods and services over the next two years. According to a White House representative, the additional purchases will add ½% to U.S. GDP.

Increases in the growth of our economy from the additional Chinese purchases could mean better earnings for the U.S. companies involved and higher stock prices ahead.

Other aspects of the Phase One deal include China opening their markets to foreign entities, especially in the financial services sector. The agreement requires China to speed up applications from financial companies seeking to access the Chinese markets. The deal names our major credit card companies by name.

The deal also provides strong new intellectual property protections for U.S. companies operating in China. The Chinese agreed to stronger protections for U.S. company “Trade Secrets” operating in China and to impose criminal penalties to willful violators.

Most importantly, the signing of the “Phase One” trade deal hopefully signals a turning point in relations between the two countries, or at least a cease fire leading to further productive negotiations leading to the signing of the second and last phase of the total deal.

The ability to complete the deal certainly has its skeptics!

“Phase One” All Important Enforcement Mechanism

The biggest complaint around the “Phase One” trade deal centered around enforcement.

The skeptics were quick to point out that Chinese officials have agreed to new measures in the past only to ignore the agreements. Much has been said about China’s willingness to cheat, and the World Trade Organizations ineffectiveness at changing Chinese behavior.

So how is this time going to be any different? This “Phase One” deal comes with a built in enforcement mechanism.

Trade disputes typically find their way to the World Trade Organization (WTO), where arbitration is the preferred resolution mechanism. The harmed country or company files a complaint, and a panel of experts comes to a binding settlement.

The Trump administration has been a critic of the WTO, so it should not surprise anyone that the deal’s enforcement mechanism bypasses the WTO all together. Up to three rounds of negotiations directly between the U.S. and China will mediate any disputes.

If the U.S. does not like the outcome of the negotiations, we have the right to impose new tariffs.

China agreed in principal to not retaliate should new tariffs be imposed after three rounds of failed negotiations. China also agreed not to seek assistance from the WTO for any unresolved disputes.

Why would China agree to this? Should China not live up to the agreement, the entire agreement may be negated, and the U.S. is free to enact additional tariffs.

Why Might Tariffs Work as an Enforcement Mechanism?

On Friday, Chinese officials shared their economy grew at the very slow rate of 6.1% in 2019.

How slow is that you ask? China experienced the slowest economic growth rate in nearly three decades!

Many in the business community believe the Chinese manipulate their data to paint a rosier picture than the actual results, so the numbers may be worse than reported.

Tariffs are not the only issue facing the Chinese economy, but the tariffs have exacerbated their problems.

It is Hard to Fight Momentum

Stock market momentum is real.

The data regarding our economy released last week continues to show strength. Combined with easing tensions with China and Iran fears completely out of the headlines already, the stock market looks poised to continue its current run.

Last year, despite the stock market gains, money continued to flow out of equities and into bonds. The reversal of this action, while likely a sign of the current stock market run ending soon, will push the stock market higher.

Continued good earnings reports throughout the current earnings cycle may be the catalyst for the rotation to occur. If not, good earnings in the short term should still lead the stock market higher.

It may be past the time to aggressively purchase stocks based on current prices, and it should not surprise anyone if some profit-taking occurs over the next several weeks.

However, calling a "top" in the current market environment is a fool’s errand, given the persistent strength of the current uptrend in stocks.

(sources: all index return data from Yahoo Finance; Reuters, Barron’s, Wall St Journal, Bloomberg.com, ft.com, guggenheimpartners.com, zerohedge.com, ritholtz.com, markit.com, financialpost.com, Eurostat, Statistics Canada, Yahoo! Finance, www.stocksandnews.com, www.chaikinanalytics.com Chaikin Analytics, www.marketwatch.com, www.wantchinatimes.com, www.BBC.com, www.361capital.com, www.pensionpartners.com, www.cnbc.com, www.FactSet.com, W E Sherman & Co, LLC)