Citigroup has a China trade deal strategy for all the possible outcomes from the trade negotiations between Washington and Beijing.
Sectors in the crosshairs — including technology and industrials — could see the widest stock swings depending on the success of the talks, according to the report published Tuesday. While China has already started to repurchase U.S. agricultural goods and promised to protect intellectual property rules, Citigroup global economist Cesar Rojas believes any lasting outcome is far from certain.
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"The U.S. and China are still not ready for a deal, and while trade talks are scheduled to resume with high-level U.S. officials visiting China on February 14–15, the U.S. continues to set the stage for a China-containment strategy," Rojas wrote. "After President Trump noted that no deal would be announced without him meeting with President Xi, the recognition that such [a] meeting is highly unlikely to happen before the March 1 deadline increased the uncertainty around a potential escalation of trade tensions."
Rojas then laid out three separate cases for the trade talks and how each could impact the market and the varying sectors.
Bull Case (5% Probability)
Citi's bull case is characterized by a "comprehensive" trade deal with a mutual tariff rollback and a softer U.S. stance toward China. This case would include measures to reduce the trade deficit (e.g., sustained Chinese purchase of U.S. soybeans) and commitments by Beijing to safeguard intellectual property and open its markets to American investment.
The bull scenario "should be positive for markets as trade tensions between the two largest economies fade, and there should be a large boost to sentiment," Rojas wrote. "Citi strategists believe this positive scenario would have a limited overall impact, aside from benefiting industries that have been in the crosshairs thus far, as credit markets have largely discounted the risk of a breakdown in negotiations."
Citi's analysts think this scenario would be a positive for cyclical stocks and push global equities up about 10 percent by the end of 2019. Rojas added that the bull case would likely cause the U.S. Treasury yield curve to steepen and term premiums would rise. Commodities and emerging markets would be winners with gains in soybeans, grains, copper and oil.
It would also bode well for machinery stocks, said Citi analyst Timothy Thein.
"Large cap bellwethers like Caterpillar, Cummins and Eaton all trade closely on expectations for global growth, and any form of trade tension easing would help to improve sentiment," he wrote. "The major ag equipment companies (Deere, CNH Industrial, and AGCO) would benefit especially as higher U.S. soybean prices would likely trigger a knock-on rally to corn prices and carry-through to improved farmer moods and spending."
Base Case (55% Probability)
The Citigroup base case is a "veneer" of a deal, with "chances of a deadline roll-over, tariffs-limbo remains and continued China-containment strategy." This middle-ground case could include commitments by China to reduce the goods trade deficit by up to $200 billion by the end of 2020 as well as to grant greater market access for U.S. exports of agricultural and manufacturing goods. It would likely also involve some promise by Beijing to step up its intellectual property rule enforcement and downplay its Made in China 2025 plan.
The base case could serve as ground to postpone tariff escalation as the two sides work toward a permanent deal, Rojas wrote.
The base case "would be positive for markets (to the extent that such a deal is not already priced-in), but the ongoing verification process and additional restrictions may leave some doubts," the Citi economist added. "Citi strategists think there would be further vulnerabilities for industrial sectors, and that more firms would likely attempt to cascade price increases through the supply chain to avoid margin compression."
Citi strategists think that this case could buoy global equities about 5 percent by December and that U.S. Treasurys would continue to see bullish pressure amid further uncertainty. The brokerage believes the base case would be moderately positive for soybeans and some agricultural products and metals, with less impact on energy.
The base case would likely help a number of transportation companies, Citi analyst Christian Wetherbee wrote.
"In the base case trade deal, more normalized freight demand can return post air pocket and additional rounds of more consumer goods orientated tariffs would be avoided,' Wetherbee said. "This could allow general trucking rates to rebound with truckload rates benefiting more than less-than-truckload rates, as current spot market softness could potential be reversed with a pick-up in demand."
Bear Case (40% Probability)
Citi's most pessimistic case occurs if the U.S. and China fail to reach an agreement or a rollover of the March 2 deadline. Tariffs on $200 billion worth of Chinese goods would increase to 25 percent from 10 percent, it said. Citi also expects Washington would attempt to exert further downward pressure on the Chinese economy. Depending on the state of economy, Beijing could elect to retaliate with its own tariff hikes for those products already targeted in its $60 billion penalty.
China could also take "unconventional" measures like placing barriers on American investments or introducing regulatory hurdles on American companies already operating within its borders. It might also choose to reduce its holdings of U.S. securities, though that risk could be contained by potential risks to financial stability, Citi's strategists wrote.
"This scenario would have negative implications for global trade and global growth, potential for nonlinearities in U.S. inflation, and overall a negative confidence shock affecting investment decisions and market sentiment," Rojas wrote.
Citi strategists think the expected drag to global growth would be a bullish sign for Treasurys, and term premiums would remain depressed. However, the lower-term premium could be at risk if China sells its Treasury holdings. Citi strategists think that global equities could be down about 10 to 15 percent in the short term.
Consumer technology giant Apple, in particular, could be vulnerable to worsening U.S.-China relations.
"When we assess our coverage the company with the most exposure is Apple, which has approximately 15 percent of its sales into China and we note Apple's source code and IP is not open unlike the Android platform," IT hardware analyst Jim Suva wrote. "We note other large cap stocks such as IBM and Cisco have for many years de-emphasized China due to competition from Huawei and corporations which favor local China solutions."
