How Will Markets React to U.S./China Trade Deal?

US China Trade Deal

With the deadline approaching, we will find out soon what the outcome of this latest round of trade talks will be, and some wonder what will happen in the markets as well.

Many people are excited at the prospects of a trade agreement between China and the United States, which may very well be at hand very soon. This would be very good news for business in general and for the economy, as trade restriction has negative effects upon economic growth.

Growing means expanding, producing and selling more not less, and trade restrictions bring on less production, less selling, less profits, less opportunity, and more money flowing into the hands of governments rather than to business from the collection of tariffs.

We do readily perceive the lost opportunity side of tariffs, for instance a company reporting reduced sales as a result of their prices being inflated more in foreign markets and this constricting demand. There is another side to this though which also brings things down and that’s the fact that tariffs siphon off money out of the system and this serves to constrict things as well.

At home, the prices of the imports that are being targeted rise by the amount of the tariff, and it’s not just that people stop buying these things. Some may find that competitive domestic goods are now a better value and substitute with them, but many continue to buy the foreign goods and pay the premium price.

This money of course is collected by the government, placing it on their balance sheets rather than those of the companies involved. This is therefore little more than a taxation scheme, as they are taxing the imports affected, and people are paying it. This happens on both sides, and the net result is a whole lot of money taken out of the system.

This is a big reason why trade restrictions have the impact that they do upon business and upon markets. When we raise taxes, this subdues the economy, much like interest rate rises do. Both are seen as bearish by markets, and trade sanctions are seen as particularly annoying due to their being caused by artificial conditions that could be resolved to everyone’s benefit if our minds are put to it.

Trade Always Benefits All Involved

Trade is a natural win-win proposition, and expands the economy of all countries involved in trade agreements. While one side may benefit more, everyone that agrees does so with an expectation of improvement, evident in their agreement and participation.

Trade agreements are not agreements to trade as much as they are agreements to not impede it beyond a certain level. If there is no impediment, we have complete free trade, but there are usually limits set and amounts restricted.

When countries do battle with each other though, this takes us from the original position with the assortment of agreements and sanctions in place and escalates it. Less restriction means more prosperity, and more restriction leads to less of it.

This affects the bottom line of the companies that we own stock in, and affect stock prices both through our expectations of how the situation will proceed as well as from announcements of progress or lack of it.

If and when the parties do reach agreement and lay down their weapons, like when all wars end, this is a cause for celebration. When people worry, stocks go down, when they have cause to celebrate, they go up, because the mood of the market is what is being acted upon with each trade.

There are some that think that a deal here would somehow be bearish, perhaps by profit taking, maybe even because that’s what happens when trade deficits narrow.

Will Shrinking the Trade Deficit Shrink Stock Prices as Well?

We can look at how the market performed according to the size of the U.S. trade deficit and we can see that the market and the size of the trade deficit tend to move together a lot. We might then reason that if the trade deficit is reduced, markets will go down.

Jim Paulsen, chief investment strategist at Leuthold Group, sure thinks so. He tells us that “since at least 1970, U.S. stocks have done best when its trade deficit worsens.”

He explains why by pointing out that if imports rise, this means that domestic consumption is healthy, “and if exports are up, this means that foreign demand is strong. So, when we have a trade deficit, it means the U.S. is doing better.”

Paulsen provides good evidence of the correlation, although we need to avoid making the mistake of assuming this means causation. We tend to do that a lot generally, not really thinking the situation through as much as we should.

Trade deficits are influenced by several factors, and therefore when we compare situations, a narrowing deficit in one case and seeing it be reduced in another, we need to account for the influence of how it is being caused in each case.

When the trade deficit goes up by itself, this does indicate more prosperity, and when it goes down by itself, this indicates the opposite. By itself here means without government intervention, and is indicative of the health of economies.

When we put up or take down barriers, we are looking to artificially influence our trade deficits. If a trade deficit gets reduced due to contracting economic factors, the by itself part, this is different from it going down from China buying a lot more U.S. goods, something that is clearly bullish rather than bearish.

So, while we may have this correlation, when we look deeper into the matter, the fact that stocks tend to go down when deficits go down does not mean that the declining trade deficit caused the market contraction, and what caused the deficit to reduce is really the driving force behind these things.

Trade deals happen quite often, but this one really has a lot of potential to expand business. Paulsen does not think that the impact of a deal, if we do get one that is, will amount to all that much. “Both sides will declare victory, but there won’t be a whole lot of change and they will just move on.”

There probably won’t be a whole lot of change because markets have already priced in most of the impact of such a deal, not because it won’t be economically significant. The numbers we’ve already seen thrown around here are big ones indeed, but those numbers are already invested in the market to a large degree and where we go from here depends on how well we fulfill these expectations.

This situation would really have to disappoint, if we fail to reach a deal and the war then became escalated, as President Trump has threatened if we aren’t successful, but that would mean not putting the trade deficit down, as Trump seeks to do. Reaching a deal would mean that we’ve lowered the trade deficit with China by a significant amount, and a significant amount is the low threshold here on the American side of the table.

Trump has just told us that he’s willing to be more flexible with his deadline for an agreement, provided that the situation looks promising, and stock markets saw this as very welcome news and the Dow opened almost 200 points higher.

As this situation evolves, we’re bound to see more events change the landscape of the issue as well as the market’s perception of it, and we may also expect that the market will continue to react positively to news encouraging to reaching a deal.

It’s hard to imagine this effect being turned on its head if and when this trade deal gets done.