(08 October 2019 ) DAILY MARKET BRIEF 2：A game plan for US-China trade talks

Our base case is for only modest progress, and given the recent deterioration in economic data, we retain a tactical underweight position in equities while awaiting the result, preferring carry strategies.

That said, we will be watching events closely, and it is possible, if unlikely, that talks produce a grand bargain.

What outcomes are possible?

Our base case, to which we assign a 50% probability, is for only modest progress in this round of talks. Modest progress averts further escalation while failing to resolve conflicts over intellectual property and subsidies. We assign a 35% probability to our downside scenario, in which further escalation leads toward a US recession, and a 15% probability to our upside scenario of a comprehensive trade deal.

1. Talks break down: This would heighten the chances of further rounds of trade retaliation. We consider this outcome unlikely, since it would increase the threat of a US recession ahead of the 2020 presidential election.

2. Negotiations continue: The US and China fail to reach a deal but announce that talks will continue. With this outcome, we would expect the full set of tariff increases in the pipeline to come into effect. It would be a setback for economic growth, but markets could take comfort if the US and China announce a date for a next round of talks.

3. A truce is reinstated: China agrees to step up purchases of US agricultural goods and grants improved market access to certain US industries. In return, the US agrees to postpone implementing the latest round of tariff increases. This would be moderately positive for markets in the short term, but the ongoing uncertainty would continue to hamper business investment.

4. An interim deal is reached: Scheduled tariff increases are suspended indefinitely, and the US could agree to roll back restrictions on Chinese technology firm Huawei. This would likely push markets higher.

5. A grand bargain is struck: The US agrees to roll back existing tariffs on China in return for agreement on an enforcement mechanism. While we assign only a 15% probability to this outcome, it remains possible. We have seen signs that some of President Trump's core supporters are losing patience with the trade war. This may encourage him to make bigger concessions. This outcome is expected to spur a more marked upswing in stocks. It would also increase the economic impact of the Fed's recent rate cuts.

What does this mean for investors?

Against this uncertain backdrop, we have been cautious on stocks and economic data has worsened.

But we acknowledge that markets could move higher through the week, particularly if a trade deal is reached. Investors looking to position for this potential outcome in advance could consider adding call options on S&P 500, which are attractively priced at present, in our view.

Our positioning farther out will partly depend on the result of the talks, and on the market's reaction to them. The relative appeal of adding to or reducing exposure to US stocks will depend on the outcome of the negotiations, the economic backdrop, the willingness and ability of global policymakers to stem the slowdown, and where the market is trading.

By UBS