Stocks rose again on Friday amid optimism that the G-20 meeting wouldn’t produce any unwanted surprises. The bond market was quiet with the 10-year Treasury yield settling around 2.0%.
While there were a lot of headlines over the weekend related to the G-20 meeting and President’s Trump brief foray into North Korea, the news was about as expected. The imposition of new tariffs was delayed while the U.S. and China restarted trade talks. China agreed to buy a bunch of soybeans and the U.S. slackened some restrictions on the sale of certain U.S. products to Huawei. Mr. Trump’s brief visit to North Korea may have led to a restart to nuclear non-proliferation. But talks aren’t solutions; they are simply the stepping stone. The U.S. wants to both dominate and dictate economic rules of engagement to China. China, in turn, wants to go its own direction, often in contradiction to U.S. policy. Finding a middle ground both sides can accept may take a very long time. Meanwhile, markets face risks that when the pace of progress slows or even stops, President Trump will revert to his number one weapon of choice; tariffs. In his mind, and in the minds of his key advisors, tariffs are what give him the most leverage. Indeed, if there is one commonality to Mr. Trump’s foreign policy actions, it is the use of tariffs and economic sanctions to gain leverage whether it be the threat of tariffs against Mexico to contain the flow of migrants across our southern border, or to prevent Iran from attaining a nuclear power capability.
For markets, tariffs serve as a tax and a growth retardant. If current earnings forecasts hold true, U.S. corporate earnings will fall for each of the first three quarters of 2019. Tariffs alone aren’t the culprit. Equal blame rests with the impact of a strong dollar during the first half of the year. But tariffs clearly produce a headwind. While markets might be relieved that the immediate threat of increased tariffs has diminished, none of the current confrontations that led to the imposition of tariffs have been resolved. China and the U.S. are a long way from reaching any sort of solution. Hawks in both countries will insist on tough terms. Whether it is possible to reach an agreement that placates hawks both here and in China is an unanswered question. Migrants continue to flow to our southern border. The new bill passed last week providing over $4.5 billion in humanitarian relief may lessen some near term pressures but it doesn’t solve the basic issues. The stalemate with Iran continues. Iran seems likely to keep military pressure on and threatens to increase the level of enriched uranium to levels beyond limits imposed by the earlier pact that Mr. Trump walked away from. Nonetheless, crossing that barrier will force our European allies to take sides, something they don’t want to do. In the meantime, we have ratcheted up the level of sanctions perhaps forcing further action, either aggressive or conciliatory, from Iran.
In sum, while the relief of short term pressure this past weekend is certainly welcome, it won’t change economic or earnings forecasts for anyone. Tariffs in place remain in place, and the big mover of future earnings forecasts will be management commentary coinciding with the release of second quarter earnings beginning in about two weeks. This will also be a big week for economic data culminating in Friday’s employment report for June. Certainly if the data for any of the major reports turns out to be outside of general consensus, it could be market moving even before earnings season begins.
Besides earnings, the other major influence on stock prices is long term interest rates. The Federal Reserve has signaled that it is highly likely that there will be a cut in the Fed Funds rate of at least 25 basis points at the end of this month. But a cut in short term rates doesn’t mean a cut in long term rates, and that is what is the key determinant to stock prices. If the Fed cuts rates to stimulate growth, one can argue whether that will reduce or increase long term rates. If a cut is stimulative to long term growth, one could argue that it would serve to increase inflationary pressure and lead to an upward move in long rates. If one presumes the Fed is behind the curve and a cut is too little too late, rates will continue to decline. Time will tell.
The bottom line is that with all the positive politics from this weekend, (1) nothing much has changed in regard to current economics and, (2) the political landscape isn’t likely to create additional economic good news any time soon. That brings this week’s economic data and second quarter earnings to come shortly thereafter into sharper focus.
Stocks have tended to hit a ceiling when reaching 17x forward earnings over the past several years. The exception was 2017 when stocks rose throughout the year and ended just shy of 18x projected results. That was reversed in February 2018 when stocks fell 10% in less than two weeks. Stocks today sell for about 17x projected earnings suggesting that multiple expansion requires a permanent reduction in long rates or a significant increase in projected earnings, both somewhat unlikely. Most of the political good news is now behind us. Stocks may celebrate with a strong opening today but I question how long lasting a rally will be without very solid economic data throughout the remainder of this week. Any sustained rally will require both better than expected Q2 earnings, lower long term interest rates or much better than expected economic data. Without any of the three, stocks are likely to languish. They may not go into serious decline; low rates and good earnings are still an investor’s best friend. But the risk is to the downside if earnings fail to match expectations.
For now, I think a cautious approach is appropriate but not a fearful one. The economy remains solid and there are few indications of recession any time soon. Earnings should begin to improve later this year and one can’t argue against the thought that political risks have lessened. One could troll for bargains during earnings season and weed out those companies continuing to disappoint. I expect a choppy market through the summer, no reason to panic and no reason to chase either.
Today, Pamela Anderson is 52. Dan Aykroyd is 67. Deborah Harry turns 74.
James M. Meyer, CFA 610-260-2220