Consensus reactions to the China-US deal are very skeptical, but may be missing the broader point.

Key Phase I agreement terms in addition to China’s commitment to increase US imports in 2020/2021:

  • Increased Chinese penalties on IP infringement and trademark violations
  • General language restricting forced technology transfer as a condition of market access
  • Broad reductions of Chinese import restrictions on US agricultural goods
  • Financial services liberalization (expansion of US underwriting, rating agencies, banking, electronic payments services, asset management, etc.)
  • Ban on competitive devaluations
  • Some language on dispute resolution

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MR. MICHAEL CEMBALEST:  Good morning.  This is Michael Cembalest with the eye in the market podcast.  Just some quick comments on the phase 1 China US deal.  Most of the consensus reactions have been pretty negative and skeptical, but I think they're missing the broader point.  You can read elsewhere about what they agreed to, I'll just give you some key terms and conditions of the deal.  China agreed to by another 200 billion in U.S. exports over a baseline, 2017 level. 

There were some commitments by China to increase penalties on intellectual property infringements and language around you don't have to give China your technology plans as a condition of accessing their market.  There were some larger broader reductions of Chinese important restrictions on U.S. agricultural goods.  Lots of financial services liberalization, most of which was already underway.  A ban on competitive devaluation and some language around dispute resolution.  As I mentioned most of the consensus opinions are pretty skeptical that one of the Chief Economists in J.P. Morgan's Investment Bank doesn't believe the trade deficit is going to change. 

Because all it's going to do is increase demand for U.S. imports, reduce the attractiveness of some of these exports to countries other than China because of an impact on the exchange rate.  And so then the net trade deficit won't change.  Other people have commented on how all that will happen is the U.S. trade deficit will be rearranged and we'll have a smaller deficit with China and a bigger one with everybody else.  There is concerns about the fact that so far this trade war has been kind of a loser.  Most of the data shows that U.S. consumers have absorbed 100% of the tariff costs. 

They took a large bite out of global GDP and earnings growth and that the deal is not good enough to reverse some of the negative momentum that we saw towards the end of last year, in terms of trucking employment falling, rising farm bankruptcies and things like that.  So there is a lot of policy skepticism around the fact how can China import so much more U.S. manufactured goods at the same time that the U.S. is also imposing all of these large sanctions on Huawei, which is one of the biggest customers of U.S. technology firms? 

Similarly, won't all the problems at Boeing be another problem for this deal, because how can China reach this manufactured goods imports target given their decision to switch recently from Boeing to Airbus?  Other concerns are about clauses in the deal saying that the agricultural commitments only have to be met according to market conditions, which is obviously a clause that means different things to different people.  And there is rampant skepticism about China's ability to really change their intellectual property behavior. 

They've made a lot of these promises before, hasn't done much, and China's legal system really isn't set up to start processing some of these cases.  It's not known for its openness, transparency, or fairness.  And then almost everybody is saying that the phase 2 talks won't yield any results in the future because that's where they intend to cover China's domestic subsidies to their champion companies, national owned companies and that they won't change. 

And then there's just other skepticism about the fact that China and the U.S. have a dispute resolution which would allow either side to restart the trade war if it thinks that the other side has abrogated terms of the agreement.  And then lastly I got a lot of feedback that the people that thought the deal was just time to drown out the impeachment hearings, and Trump then use the signing session as an opportunity to talk about Lindsey Graham's golf game and the max 3737 issue.  And lastly he asked Mary Erdoes who was our asset management CEO, who was in attendance, to thank him for the firm’s earnings. 

A lot of the skepticism is a little bit beside the point.  Let's think about the alternative where nothing was done, where the administration just kept the policies going as usual.  What did we have up until that point?  We had unchecked Chinese mercantilism, and with China having the least receptive foreign direct investment inward investment regime other than the Saudis.  In other words, harder to invest in China anywhere except Saudi Arabia.  More and more rounds of these China US strategic economic dialogue talks that Bush and Obama administration has held for years since 2006 and which basically accomplished nothing.  To 300 to 600 billion dollars a year of annual losses to the economy from counterfeit goods, pirated software, theft of trade secrets, things like that. 

And then the continued hollowing out of U.S. manufacturing communities.  There's been more and more research showing that very tight connection between rising Chinese exports and declining U.S. manufacturing jobs.  And then more specifically the negative impact of Chinese competition on U.S. workers that don't have a college degree, compared to the much smaller impact on U.S. workers that do have a college degree.  And at this point I'm not too concerned about the impact of this deal on tariffs on U.S. consumers.  They've received an enormous windfall over the last 15 years from Chinese trade and a redistribution from consumers back to U.S. manufacturing workers. 

If it happened, we reverse a very small part of that distortion.  And there is a ton of research out there showing the impact of increased Chinese imports in the U.S. leading to a very large fall in that industry CPI.  And that's basically been going on since 2000, 2001.  There is actually some data showing that increased Chinese imports generated benefits to consumers through lower prices, equal to about 100,000 dollars per lost manufacturing job. 

So I think the bigger picture here is that like a lot of divorces, that we're all familiar with, unwinding the status quo was always going to hurt and was never going to be easy.  China showed absolutely no intention of responding to U.S. concerns until this tariff war started and it's unreasonable to think that any serious renegotiation of trade and investment could ever have been achieved without any economic damage on both sides. 

We had over a decade of these strategic dialogue talks that basically involved a lot of stonewalling on both sides.  So I don't know if this deal is going to lead to fairer trade, but from a U.S. perspective anyway it moves in that direction.  And it also tries to codify some kind of acceptable rules of engagement for the largest participants in the global economy, specifically China.  And for this reasons I think it deserves a little more credit than it is getting.  Again, particularly given the lack of, total lack of progress in prior Republican and Democratic administrations on this topic.  So there is risk of re-escalation and I don't think foreign direct investment in both directions will ever go back to where it was. 

But the worst-case trade war outcomes look like they're off the table.  The Chinese purchase commitments of U.S. exports are pretty substantial indications of a willingness to compromise, even if they're not reached in full.  And some capital spending plans are now going to get restarted around the world, which is what the equity markets are responding positively to.  So that's just some brief comments on the trade conflict.  Thank you for listening and we'll talk to you soon.

FEMALE VOICE 1:  Michael Cembalest's, eye the market offers a unique perspective on the economy, current events, markets, and investment portfolios and is a production of J.P. Morgan Asset and Wealth Management.  Michael Cembalest is the chairman of market and investment strategy for J.P. Morgan Asset Management and is one of our most renowned and provocative speakers.  For more information, please subscribe to the eye on the market by contacting your J.P. Morgan representative.  If you'd like to hear more, please explore episodes on iTunes or on our website.  This podcast is intended for informational purposes only and is a communication on behalf of J.P. Morgan Institutional Investments, Incorporated. 

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