Stocks suffered their biggest decline in months yesterday. While profit taking would have been a good enough explanation, heightened rhetoric between the U.S. and Iran, a statement from a White House spokesperson to the press toning down expectations for the Trump-Xi summit this weekend, poor economic data out of Europe and weak housing data here all contributed to the decline. As previously noted, the stock market has been discounting a lot of good news lately. Any threats suggesting expectations have to be tempered brings out the sellers.
Mr. Trump’s pattern has been to speak loudly, forcefully, and often belligerently, before taking a step back. Most recently, he went to the brink of initiating military action against Iran before pulling back. After criticism suggesting weakness on his part arose, he implemented new sanctions and ramped up his rhetoric. Where events go from here remains in doubt, but clearly we are closer to military confrontation than we have been in a long time.
China, however, is the far biggest economic threat. A few months ago, it appeared possible that an economic treaty between the two parties was near enough that a final summit between Trump and Xi at this weekend’s G-20 meeting would represent the crowning achievement. But it appears that the Chinese negotiators got pushback from Xi and others causing talks to breakdown. Trump immediately threatened additional tariffs to start in July. Even as negotiations have restarted, and Treasury Secretary Mnuchin said this morning that the two sides are 90% of the way toward an agreement, everyone knows the last 10% is always the most difficult. While it is encouraging that both sides are talking again, no agreement will be reached without some further concessions from each side. Logic may suggest that will happen, but Trump likes to be unpredictable and China often is. The consensus expectation is that the two sides will leave the G-20 meetings encouraged enough to keep working toward a solution. Such an outcome would be accompanied by a pledge by Trump to defer any further tariff increases as long as forward progress continues. Markets will be OK with that but, ultimately, a prolonged stalemate with existing tariffs remaining in place isn’t a good outcome. The prospects of an agreement by year end are baked into record stock prices.
The problem is that the last sticking points offer stark differences. We want to see better protection for intellectual property rights, the end to forced technology transfers, and easier access to Chinese markets. Further, we want to expand exports to China (notably commodities) and we want the unilateral right to raise tariffs on Chinese exports without reprisals on their part should we deem China in non-compliance of any aspect of the agreement. That is an awful lot for China to swallow without essentially giving up a thing. We haven’t even agreed to eliminate tariffs in place until sometime after an agreement is implemented and we can be assured of Chinese compliance. The obvious compromise would be for stronger and enforceable rules relating to intellectual property protection and a somewhat less one-sided enforcement mechanism. To compound the problem, the U.S. side is split. Trade Representative Lighthizer and advisor Peter Navarro are trade hawks who strongly believe that tariffs are our best enforcement mechanism. On the other side, economic advisor Larry Kudlow and Secretary Mnuchin are against the use of tariffs as they serve as a tax on everyone and slow economic growth. Trump himself has declared that he is a tariff guy. That makes reaching a final deal more difficult.
Separately, Mr. Trump continues to rail against the Federal Reserve. The market’s yield curve, which has turned negative, suggests that one or more rate cuts are needed. While the Fed has continued to assert its independence and will defy White House interference, increasingly the FOMC members see a need for at least one rate cut. Increasingly, some are suggesting a 50-basis point cut at the end of July instead of the customary change of 25 basis points. A cut of at least 25 basis points in July appears virtually certain today. But that might not be enough to soothe markets if interest rates don’t stabilize between now and then.
Mr. Trump wants to deflect blame virtually all the time. The Fed is a convenient foil to explain away a weakening economy. The negative yield curve adds fuel to his rants. But facts suggest that the Fed is hardly the major problem. Tariffs are clearly one reason for slower growth. Some believe that worldwide growth is 50-100 basis points less than it would be without the tariffs we have implemented over the past 18 months. European central banks are still easing and have indicated that they might accelerate easing actions later this year. China’s central bank has been easing aggressively for months. With substantial U.S. bank reserves parked at the Fed windows, one can hardly suggest that tight money is a key culprit in the slowing economic growth picture. Would a rate cut help to reaccelerate growth? Sure it would. But a cut or two won’t add 100 basis points to our growth rate without a China trade deal, less tariffs, and more economic policy consistency worldwide.
In addition, investors need to be careful what they wish for. Should the Fed cut rates 50 basis points (still not the consensus expectation) and the bond market responds to the prospects of increasing growth with lower prices (and higher yields) on 10-year Treasuries, then the P/E ratio for stocks would fall. Over the short term, meaning in front of the late July FOMC meeting, the path of least resistance for markets is for long rates to continue to move lower. Second quarter corporate earnings should be OK, but many companies will be quite sober going forward, especially if higher tariffs on Chinese goods remain any sort of threat.
Yesterday, Lennar#, a major homebuilder, reported good quarterly earnings. But in its post-announcement conference call it warned that tariffs, both current and proposed, would increase the cost of an average home by about $500. Home prices are determined by the market. Lennar cannot simply raise prices as an offset. It competes against every existing home up for sale. Those homes are not exposed to higher tariffs. Thus, Lennar and its suppliers will have to eat the costs of tariffs. The $500 I just mentioned is Lennar’s share of the increased costs. American companies that import product Lennar buys will have to eat some of the tariffs as will the Chinese suppliers.
We live in a world that has too much capacity. How do I know? Because it is quite obvious that sellers everywhere lack pricing power. That only happens when supply exceeds demand. Raising costs during periods of oversupply suppresses economic activity. That is why worldwide trade volumes are down. That is why profit margins are getting squeezed. That is why, despite, a modest rise in orders, Lennar is going to suffer because it might have to incur extra costs of as much as $500.
Tariffs undo much of the good from the cuts in corporate tax rates. Corporate earnings, which earlier this year looked like they could rise 7-10%, now look likely to be up 0-5% for the year. The reason stock prices are up isn’t about expanded sales and earnings. It’s all about lower interest rates and higher P/Es. Maybe that persists for a while longer. But if rates fall too far, the messages of possible recession or even deflation won’t be well received.
The best path, and possibly the one we are on, is for lower future tariffs, a proper realignment of interest rates, higher confidence among both consumers and businessmen, and more consistent economic policy in Washington. While that is still the consensus view, any deviation probably adds to risk.
Stocks are now trading at or near all-time highs for the fourth time in a year. There is an old saying on Wall Street that there are never triple tops, let alone a quadruple top. Stocks are either going to break through to new highs convincingly or undergo yet another correction, perhaps as much as 10-20%. One can conjure up a series of events to support either. The next 30 days will be critical to the market’s direction for the balance of the year. If there is clarity to Fed policy, tariffs and Middle East tensions, stocks could move higher. But if the Fed stays behind the curve or talks with China reach another serious impasse, our 10-year economic expansion could be threatened. The one underlying positive is that Mr. Trump views the stock market as the scorecard for his economic agenda. He certainly wants it to be higher next November than it is today. He can’t control the market, but he has strings to pull that can create powerful tailwinds.
Today, Ariana Grande is 26. Derek Jeter is 45. Former Eagles quarterback Michael Vick turns 39.
James M. Meyer, CFA 610-260-2220