Trade deal still on but geopolitics complicating matters; JGB yields surge towards zero

Phase one trade deal doesn’t look to be reached by year-end
Markets finished higher after a turbulent week when prospects of a phase one trade deal was thrown into doubt once again. With Mr. Trump lashing tariffs on French wines and cheese, raising duties on steel imports from Brazil to Argentina and then making remarks that he can wait until after next year’s election to reach a deal with China sent markets into a brief tail-spin which raised fears of yet another phase of deterioration in sentiment, similar to what we saw in May. 

However, markets calmed as we approached mid-week as China indicated its continued willingness to see phase one through with talks of lowering levies for US agricultural products. Although we continue to believe that phase one of the trade deal will be reached and the planned December 15th tariffs will be avoided, it seems unlikely that any agreement will be attained before year-end as neither side are planning to have an official meeting in December. If we are wrong, and planned hike in US duties which we detailed in our last week’s publication go into effect next Sunday, then all bets are off. 

US bill condemning crack down on Chinese muslims complicates matters
The passage of the US House bill on Tuesday, condemning Beijing’s crackdown on China’s Muslim Uigher minority soon after the US president had signed the HK democracy bill into law has complicated matters. Indeed, China whose previous responses have been fairly measured throughout these skirmishes this year seemed particularly irked by this latest bill and for the first time threatening to walk away from any trade negotiations should interference with its domestic policies continue. 

This we think is because in the case of HK, China is in agreement with ‘one China, two systems’ regime. However, in the case of the alleged internment camps in Xinjiang region, China looks to have very little tolerance for outside meddling in its mainland policies. This makes the potential passage of this bill into law problematic and we will be watching events carefully to see if the US president whose grassroots support base generally have less sympathy for such external matters will veto it to potentially save the trade deal ahead of next year’s US presidential election. Indeed, we suspect he could use this as a major negotiating lever with the Chinese going forward.

Despite Japan’s big fiscal stimulus we are more excited about surging JGB yields
Moving on to our our own market in Japan, the broader stock market index, Topix managed to edge higher as the government introduced a Y13.2trn fiscal stimulus package to help offset the economic weakness caused mainly by China freeze on capital outlays which have greatly hurt Japan’s exports of capital goods. Although opinions differ about the positive impact of this package, what we were more excited about last week was the continued upward direction of JGB yields which are being mirrored in other sovereign debt markets.

Indeed, even two days before the fiscal stimulus was announced, a weak JGB auction had led to a sharp rise in bond yields as BOJ was clearly stepping aside, allowing long term rates to rise. By last Friday, a day after the fiscal package was unveiled, Japan’s 10 year government bond yield had briefly touched the symbolic zero level and finished just six-tenth of a basis points into negative territory. We think this is all part of BOJ’s big monetary policy regime change that began in early September which we have dedicated much of this publication to in the past few months with the November 10th issue solely focusing on this subject worth revisiting:

Japan stock market looks poised for big gains next year
We continue to think Japan’s stock market is positioned for strong gains next year, partly because of its cyclical gearing to global economies, most notably to China which it has a much bigger trade surplus with than the US, especially as China’s economic activity is showing signs of bottoming out. We also view Japanese stocks as far more attractively valued compared with other DMs while large corporations are finally embarking on radical restructuring programs. Big share buybacks are also very encouraging as levels for this fiscal year should beat last term’s record of Y6trn given that by August buybacks had already totalled Y4trn.

We think government’s fiscal spending plans and subsequent financing should help BOJ’s cause by issuing more longer dated bonds and help steepen the curve while the central bank tapers its longer dated JGB purchases. As long as the yen continues to behave and not notably strengthen, we think BOJ will pursue this course to try to steepen the yield curve and help its financial industry. With financial stocks likely to continue to participate in this bounce, we think potential upside is indeed great as we stick with our year-end Topix target close to 2018 highs or just over 10% above Friday’s close. However, given Japan’s high exports gearing to China, much depends on the US/China trade talks to continue progressing.