Trade Truce: Good for Trump and Xi

But for investors, watch the Dollar...

STOCK MARKETS showed huge relief that US President Donald Trump and China's Xi Jinping are back on speaking terms, writes John Stepek at MoneyWeek in his free daily Money Morning email.

They got together at the G20 meeting in Tokyo at the end of June, and had a good chinwag about the trade tensions between them.

So what have the two sides agreed? Well, nothing much, to be honest.

Trump agreed not to introduce any new tariffs on Chinese goods (he had been threatening to raise them on another $300bn-worth). Meanwhile, China agreed to buy more agricultural goods from the US.

That will play well with American farmers, who have been among the hardest hit by the trade shenanigans so far.

Trump also relaxed a little on telecoms group Huawei. The company – deemed a threat to US national security by some – will be allowed to keep doing business with certain US companies. That was an unexpected bonus for China, and will also annoy a lot of Trump's party members.

Another unexpected event was that Trump became the first US President to enter North Korea, to have a quick catch-up with North Korean dictator Kim Jong Un. Whatever your geopolitical take, markets generally respond positively to decreasing tensions, so they'll approach this with a "glass half-full" mentality.

It's not clear that any of this will last any longer than Trump's previous "thaws". It could all be reversed in a tweet any time. And none of it represents a big change in the current state of affairs – the US and China are still imposing tariffs on each other.

But what you need to remember is that markets are priced off expectations. All that really matters is whether those expectations are surpassed or undershot. In this case, the trade talks were more positive than investors had thought possible. As a result, markets have rallied on the outcome.

The other good news for markets is that the Chinese Renminbi (or Yuan) strengthened. It's now sitting at below ¥6.9 per Dollar.

Why does that matter? The magic number seven is seen as a bit of a line in the sand. Conventional market wisdom agrees that if the exchange rate gets to the point where one US Dollar will buy you seven or more Chinese Yuan, then that's a sign that China is willing to devalue aggressively.

That in turn would unleash a deflationary wave across the world (as Chinese imports would get a lot cheaper). It would also indicate a big change in the running of the Chinese economy.

This is something that – unsurprisingly – had been of concern to markets. Now, instead, the hope is that it's the Dollar that will weaken, which would in turn, be good news for "risk-on" assets.

Most analysts are still sceptical of this achieving anything permanent. As Capital Economics argued before the G20 summit:

"On balance we think it more likely than not that 25% tariffs will be applied to all Chinese imports by early next year and that China will retaliate with tariffs and non-tariff measures."

The research group also reckons that "the currency will be allowed to go through ¥7 per Dollar if trade talks collapse."

Diana Choyleva, chief economist at Enodo Economics, points out that this outcome was politically expedient.

"Both leaders need a truce". Trump has an election coming up next year. And Xi has the Communist Party celebrations in October – it's 70 years since Mao founded the People's Republic of China. (This year of course, also marked the 30th anniversary of the Tiananmen Square massacre, but China wasn't for talking about that.)

So political expediency trumps ideology for now. Yet the tricky thing is that there are too many fundamental differences between the US and China. As Choyleva puts it, this is about far more than just trade.

"It's part of a longer-term Great Decoupling that stems from a conflict over technological supremacy and geopolitical power. This is about redefining the world political and economic order, a process that will see periods of relative calm and also periods of significant turbulence."

So we have this as a long-term backdrop. But what does that mean for investors?

The reality is that the most important thing right now is what happens to the US Dollar. A weaker Dollar means that the risk of the Yuan sliding decreases. It also means S&P 500 earnings will be under less pressure. So the trade talks are frankly, for investors, a sideshow right now.

This question of the Dollar is, to a great extent, in the hands of the Federal Reserve, America's central bank. My own gut feeling is that we're in for a weaker Dollar. But keep an eye on the economic data.

They might not change the eventual outcome, but they'll certainly have an impact on the market's level of confidence about lower rates soon.