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Investors counting on a big rally when China and US trade talks conclude could be disappointed

Key Points
  • Stocks are moving higher on the prospect of a trade deal, but some strategists say the market may sell off if the deal is not substantive enough or retains existing tariffs.
  • Bank of America strategists said stocks could gain 5 to 10 percent if the U.S. agrees to a deal that eliminates all tariffs and China gives full access to its markets and agrees to a plan on intellectual property rights with enforcement.
  • Strategists expect a deal of some sort, but some are skeptical it will be as broad as the U.S. is seeking.
U.S. President Donald Trump, and his Chinese counterpart Xi Jinping during a welcome ceremony outside the Great Hall of the People in Beijing, China, on Nov. 9, 2017.
Qilai Shen | Bloomberg | Getty Images

A trade agreement between the U.S. and China could result in a "sell the news" market reaction, if the deal comes up short or does not remove existing tariffs, traders said.

President Donald Trump indefinitely dropped his threat to raise tariffs to 25 percent from 10 percent on $200 billion in Chinese goods, ahead of the March 1 deadline for trade progress. The president said talks were productive and he looks forward to signing an agreement with China's President Xi Jinping.

Stocks surged Monday after the weekend announcement, with the Dow up about a half percent in afternoon trading and Chinese shares up more than 5 percent overnight.

But some strategists say Trump could eventually move forward on a deal that does not satisfy all U.S. concerns including Chinese subsidies to its businesses and how it treats intellectual property.

"A partial deal is increasingly priced into the equity market amid recent positive rhetoric out of the White House. In the event of a real deal, we would expect 5-10% upside for US stocks , with direct and indirect benefits to EPS (unleashed spending) could benefit global cyclicals." wrote Bank of America equity strategists. "Under a partial deal, we would expect a 'sell the news' knee-jerk reaction, and under a full-blown trade war could erase most, if not all, of its YTD gains."

WATCH: Trade deal or no deal, the U.S. and China are still fighting for global power

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Trade deal or no deal, the U.S. and China are still fighting for global power

The strategists note a partial deal could include some changes around intellectual property but no change in the 2018 tariffs put on Chinese goods, and those would be kept in place as an enforcement measure. China would increase its purchase of U.S. goods. A real deal would include bigger changes on intellectual property regulations and enforcement.

The Bank of America strategists said a survey of fixed income fund managers show a majority expect that type of narrow trade deal that ends some existing tariffs. Just 13 percent said they expect a deal to address broader issues, including intellectual property.

"It's the tariffs that have the most impact on the economy," said Peter Boockvar, chief investment strategist at Bleakley Financial. "I think it depends on what happens to the existing tariffs. Do the existing tariffs come off or do they remain as an enforcing measure. The market wants the tariffs gone...if you have an agreement and those tariffs are still there, that would not make people happy."

The Bank of America analysts estimate that one-third of the three percent decline in earnings forecasts for 2019 are the result of tariffs.

"A 'real deal' scenario could reverse the direct impact from 2018 tariffs and potentially could boost sales in China, adding back the estimated 1% negative impact to S&P EPS,"" the strategists wrote. "A partial deal scenario (existing tariffs remain, no increase in tariff rate) would have no direct impact to S&P EPS."

Evercore ISI strategists point out there is no talk yet of removing existing tariffs.

"We believe this coming 'deal' will fall far short of satisfying most structural complaints on how China behaves economically. And, 'enforcement' in the case of non-compliance remains out of reach. So, global companies will remain doubtful about new plans on investing, producing, hiring and sourcing," noted the Evercore ISI analysts.

Strategas Research's Dan Clifton said the existing tariffs may be the price China pays if it doesn't change its ways.

"We are having a harder time seeing a path to removing existing tariffs, which will be largely dependent on the Chinese making significant structural reforms. If a final deal is reached, we would not be surprised if the commentary downplays the changes made. Still, China tariff rates have fallen in one year and companies are being granted more access to the Chinese market. While a delay in tariffs is welcome news, a final deal needs to be completed soon for capex to move higher," he wrote, in a note.

Source: Strategas Research

Clifton said the U.S. has made some gains as it pressured China on trade. "A back-of-the-envelope calculation suggests that the average tariff rate for goods coming into China fell from 9.8 percent in 2017 to 7.5 percent in 2018," Clifton noted adding more companies are being allowed into China without joint venture requirements.

U.S. Trade Representative Robert Lighthizer testifies on trade before Congress Wednesday, and he may provide more details on what is under discussion.

"Trump's trade hawks say privately that several issues aren't resolved yet — including how to enforce a deal — but if The Boss wants a late March celebration with President Xi at Mar-a-Lago, he'll get one. And that prospect is very bullish for investors," noted Greg Valliere, chief global strategist at Horizon Investments.

Fundstrat's Tom Block said both Trump and Xi have a lot at stake, with Trump focusing on the 2020 election and Xi concerned about China's economy.

"They both have a stake in having something that works. I don't know what the teeth are but it's going to be meaningful for both sides. The Chinese are going to commit to buying a lot of agricultural stuff and they're going to be more forthcoming," Block said.

Block expects the agreement to include intellectual property.

"The intellectual property issue is very important...It could be weak and I think enforcement will be an issue. Lighthizer is clearly not a wimp on these issues," said Block. A big part of an agreement will boost China's agriculture spending.

"The fact is that both sides need an agreement. President Xi has seen a weakening of China's growth, and President Trump needs to assure farm state voters that he is on their side," he noted.