Trade tensions end

Doug Lippoldt

Chief Trade Economist

HSBC Bank plc douglas.lippoldt@hsbc.com +44 20 7992 0375

Dr. Murat Ulgen

Global Head of Emerging Markets Research

HSBC Bank plc muratulgen@hsbc.com +44 20 7991 6782

Paul Mackel

Head of Emerging Markets FX Research

The Hongkong and Shanghai Banking Corporation Limited paulmackel@hsbc.com.hk +852 2996 6565

John Lomax*

Head of Global Emerging Markets equity strategy

HSBC Bank plc john.lomax@hsbcib.com +44 20 7992 3712

Dominic Bunning Senior FX Strategist

HSBC Bank plc dominic.bunning@hsbcib.com +44 20 7992 2113

Julia Wang

Economist, Greater China

The Hongkong and Shanghai Banking Corporation Limited juliarwang@hsbc.com.hk +852 3604 3663

* Employed by a non-US affiliate of HSBC Securities (USA) Inc, and is not registered/ qualified pursuant to FINRA regulations

The post-G20 truce in China-US trade tensions initially gave some relief to the market, as negotiations got underway

But the outcome of the trade tensions remains uncertain, and trade prospects are further clouded by WTO disputes and Brexit

An end of trade tensions could boost investors’ sentiment and have a positive impact on China and EM assets

Taking trade to the brink and back

Rising trade risks

After a strong trade recovery in 2017, goods trade growth levelled off in 2018. Tough trade policy actions by the US targeted China specifically, but also affected partners around the world such as Canada, the EU and Turkey, among others. In Europe, the Brexit process added to the trade uncertainty.

Turning point?

Trade policymakers have delivered a few recent breakthroughs and a few more may be pending that could help to revive trade prospects. October 2018 witnessed the ratification of the Comprehensive and Progressive Agreement for Trans-Pacific Partnership, a deeply liberalising accord among 11 Pacific Basin nations with a combined GDP of USD10trn. The EU and Japan are advancing in the ratification of their bilateral trade deal, which will remove most duties, increase agricultural market openness, and tackle challenging non-tariff barriers (e.g., regulation) in areas like autos and pharmaceutical products. Neither of these trade deals includes China or the United States. And, facing commercial pressures, businesses engaged in trade in the US and China intensified their advocacy for market-friendly reforms to address the mutual grievances between these two nations.

The US and China could make a move in 2019

Trade policy developments in the rest of the world and mounting costs could encourage the US and China to build on the initial progress arising from the positive bilateral meeting of Presidents Trump and Xi on 1 December 2018 following the G20 meeting in Buenos Aires. It is possible that by early 2019, they could agree on measures to improve respect for intellectual property and limit trade-distorting state support for businesses. Under such a scenario, their mutual punitive tariffs could be removed.

Trade policy bliss

These positive steps would be reinforced during 2019 if the US were to agree to re-join the CPTPP. This could set the Pacific Basin region on course to potentially boost trade by 10% and GDP by 1% (PIIE, 2017). In the face of such a move, China and 15 other Asian-Pacific nations might finally conclude the Regional Comprehensive Economic Partnership, which would reduce tariffs and facilitate investment across the region. That would contribute gains to regional GDP of roughly 0.4%, according to PIIE. Progress in the Belt and Road Initiative could further contribute to the easing of impediments to trade. As a consequence of these and other actions, trade growth might revive in what could be a sustained manner.

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Investment implications

Growth expectations and “risk-on” would impact FX

In our view, there would be two channels through which an end to recent trade tensions would impact FX markets. The first would be the direct trade linkages. The second would be a likely pick-up in global growth expectations and a subsequent “risk-on” sentiment.

First and foremost, the RMB would likely retrace some of the depreciation seen in 2018, although it does still face a slowing domestic economy. Elsewhere, the likes of the AUD, NZD, TWD,

KRW, CLP, PEN and BRL would likely outperform as they sit within the group of “risk-on” currencies. Currencies in other, small open economies such as CEE3, SGD and THB might also benefit due to their general trade openness, despite being less directly linked to the US and China. The USD, JPY, CHF and to a lesser degree the EUR, would all likely face downward pressure as safe havens. MXN and CAD have already benefitted from the signing of USMCA agreement so would be less likely to benefit.

GEMs would be a near-term winner

Global trade regaining its vigour would be unambiguously positive for China, the global economy and the risk appetite for EM at large. One unexpected consequence could be an upside surprise in Chinese growth as the country ends up over-stimulating with a series of measures already in store in the anticipation of a prolonged and drawn-out trade tension. This upside growth surprise would be positive for EM and cyclical commodities at the onset. One should expect countries that are more exposed to China through trade and/or to global supply chains to perform particularly well. In that regard, Asian countries as well as commodity exporters in LatAm and CEEMEA (Chile, Brazil, South Africa, Saudi Arabia and Russia in particular) would see a pick-up in their economic activity.

Over the medium term however, a resolution on the trade front might also result in an acceleration of Fed’s tightening cycle beyond more subdued market expectation, a further tightening in global financial conditions which would negatively impact EM risk appetite (particularly sizable for countries with large external financing needs and/or high FX denominated debt). Over the longer term, expansionary policies in China might elevate inflationary pressures forcing EM central banks to turn hawkish.

Positive impact on EM equities

If concern about US trade policy abated, EM equities broadly would benefit; within EM, China, Korea and Taiwan could benefit disproportionately. Commodity countries exporting more to Europe and China than to the US have been relatively unimpeded (Russia and Brazil). Korea and Taiwan, both manufacturing producers with a US focus, have been hurt more meaningfully.

MSCI market overseas revenues vs exports to GDP (ranked by overseas revenues)

Source: Data for financial numbers of FY 2017, MSCI, Refinitiv Datastream, World Bank, HSBC

Wai-Shin Chan, CFA

Head, Climate Change Centre of Excellence

The Hongkong and Shanghai Banking Corporation Limited wai.shin.chan@hsbc.com.hk +852 2822 4870

Ashim Paun

Director, Climate Change Strategy

HSBC Bank plc ashim.paun@hsbcib.com +44 20 7992 3591

Tessie Petion

Head of ESG Research, Americas

HSBC Securities (USA) Inc. tessie.d.petion@us.hsbc.com +1 212 525 4866

Lucy Acton

ESG Analyst

HSBC Bank plc lucy.acton@hsbc.com +44 20 3359 3365

David Faulkner Economist

HSBC Securities (South Africa) (Pty) Ltd david.faulkner@za.hsbc.com +27 11 676 4569

Michael Ridley

Green Bonds & Corporate Credit Analyst

HSBC Bank plc michael.a.ridley@hsbc.com +44 20 7991 5918

Peter Barnshaw Analyst, Credit Strategy

HSBC Bank plc peter.barnshaw@hsbc.com +44 20 7991 5022

The frequency and severity of extreme weather events did not relent in 2018. Europe saw unseasonable cold spells and summer heat waves; floods hit Japan, India, Australia and China; destructive typhoons wreaked havoc across SE Asia and wildfires raged across California, Greece and Sweden.

Besides physical damage and longer-term social effects, these episodes represent growing climate risks across economies, businesses and society – all with investment implications:

Cape Town continued to suffer from prolonged drought in early 2018, weighing on economic growth prospects (Running dry in Cape Town, 8 February 2018). Cape Town’s drought posed risks to growth and net exports in the region. Tourism was impacted and agricultural productivity dropped.

Floods in Kerala, India in 2018 displaced 1m people (3% of the state population), causing an estimated USD2.85bn in asset impairments and damaged one third (70,000km) of

Kerala’s total roadways. This highlights the importance for development to be “climate proof” (Kerala floods highlight vulnerability of development, 24 August 2018).

Climate change can be described as “a change in average weather”. Whilst individual weather events are not caused directly by climate change, the chances of more extreme events occurring in any given year are higher (region and type specific) and the severity of these can be magnified by climate change.

Negative impacts can be profound, including the loss of life, infrastructure damage, supply chain disruption and productivity slowdowns. Financial implications for companies and governments can be large. Agricultural commodity markets can be disrupted as weather events affect yields and harvests, and bonds and equities hit by climate events can see downgrades and declines. We believe these risks and their associated costs (Chart 1) may not be fully priced in by investors.

Investment implications

As climate change damage costs become evident, and governments try to limit it without imposing heavy costs on their citizens, a wide range of securities could be impacted.

Preparing for climate impacts requires investment. The US utility Southern California Edison estimated that making its equipment more fire resistant will cost USD670m over three years. San Diego Gas and Electric spent more than USD1bn over 10 years to fireproof its equipment.

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1: Extreme weather events are growing in number and impact

40 20

PG&E equity and bond prices hit

Insurance losses rising

Agriculture prices volatile

But full preparedness is expensive and elusive. The Pacific Gas & Electric Company (PG&E) has spent USD15bn in the last five years to upgrade its equipment and make it more fire-safe yet it booked a USD2.5bn charge related to wildfire claims in the second quarter of 2018. PG&E’s share price fell by 45% after the autumn 2018 Camp Fire in Northern California, which burnt through 154,000 acres and destroyed 14,000 homes.

Indeed PG&E (Baa3Rfd/BBB-Cwn) saw its credit ratings cut three notches by Moody’s and S&P, due to its role in the 2017 and 2018 California wildfires. It also saw a sharp sell-off in its bonds (Chart 2). Elsewhere, we think there is a clear link between a Sovereign’s CDS level and climate change resilience (Chart 3) (Sovereigns and ESG, 10 Sept 2018). If more focus is given by the market to extreme events in 2019, we could see further spread widening as a result.

Insured losses from natural disasters as well as the protection gap (losses which are uninsured) have both been increasing in recent decades. We think the potential (and realisation) of rising losses could encourage governments to reassess whether these growing risks are adequately spread across the appropriate channels heading into 2019. (Insurance coverage, 20 September 2017)

Agriculture is a perpetrator and victim of climate change (Fragile Planet, July 2018). European heat waves and droughts in 2018 affected wheat production and quality, with German harvests 20% below the five-year average (German Farmer Association) and EU wheat prices at a five-year high in the summer. In economies like India, entire harvests can be wiped out by drought (Hunger rises,

12 Sept 2018). 2019 could see similar price volatility as weather patterns become less predictable.