Stocks fell sharply yesterday with all leading averages falling more than a full percentage point. Most of the damage came early amid new trade fears and some elevated concerns about Brexit. But markets stopped falling by midday and actually rallied a bit into the close. Futures are higher this morning suggesting that without further news today, the losses can be contained. While the Dow is on pace for its fifth straight weekly decline, the cumulative losses over that period total less than 5% although clearly losses were higher for companies directly impacted by trade fears or the Huawei controversy.
In times of limited corporate or economic news, markets have a habit of overreacting. Another way to say this is that markets tend to either fear the worst or submit to unbridled optimism. What we do know is that the U.S. is raising some tariffs on Chinese imports. What we don’t know is what the next step will be. Will more tariffs come in 90 days? Will the threatened next wave of tariffs be postponed? We have been hearing of auto tariffs for over a year and none have been implemented to date. For instance, some tariffs aimed at Canada and Mexico may even be reduced soon. The obvious answers to these questions are that we don’t know. But that doesn’t mean markets won’t price in future expectations. Markets often forget that one action usually begets a reaction. For instance, should Mr. Trump implement tariffs on all Chinese imports, markets would almost certainly fall sharply. Our economic growth rate would fall. The odds of a recession might increase. As we all know, Mr. Trump likes to keep score. He views the world in terms of wins and losses. While tariffs might increase his bargaining leverage, they certainly would increase America’s short-term economic pain. Tariffs are already unpopular for voters, and opinions would turn even more negative should tariffs be placed on popular consumer items. Tariffs of iPhones, for instance, might cause pain to the Chinese, but it would hurt Apple#, help Apple’s Korean competitors, and be a tax on the American public. And none of this presumes any retaliatory steps by the Chinese. Therefore, will Trump raise tariffs again in 90 days? Probably not. He might defer them. He certainly views the threat of another wave of tariffs as a bargaining chip. He expects to meet President Xi in late June. The outcome of those talks may be the key to the next step forward.
With all that said, the odds of an all-encompassing deal with China that helps our balance of trade, commits China to policing intellectual property theft, and removes all existing tariffs is unlikely. Since both Trump and Xi view the world in an “I win, you lose” fashion, a deal that allows both sides to claim victory at the same time, will be a hard one to achieve. It took many months to modernize NAFTA without meaningful changes. What we are seeking with China is a wholesale change in its behavior without any major concessions on our part.
That may be where Huawei comes in. Huawei is unique in that it is a giant Chinese company with truly proprietary technological leadership. It sells products all over the globe including the U.S. and, in particular, Europe. While there are no clear indications that the Chinese government has an economic ownership stake in Huawei, China is a totalitarian state. It is not a democracy in any way, shape or form. If (and note the word if, please) China wanted to work with or through Huawei to spy on governments, corporations or individuals, the technology exists for it to do just that. Whether China has done so to date begs the question in the eyes of our Administration. The fact that it can is enough to place severe restrictions on Huawei’s ability to sell products in the western world.
But step back. As technology advances and future devices worldwide become more intelligent, more spying and hacking is going to be a logical consequence and every entity will have to take necessary steps to protect itself. Thus, perhaps the threats against Huawei are as much a negotiating tactic as they are a serious concern over potential Chinese spying. And as part of negotiations, backing away from total bans against Huawei, as part of a broader package, might be a piece of the puzzle that will allow China to declare a “win” on its part. In similar fashion, we threatened similar sanctions previously against ZTE, clearly a rogue Chinese player, only to back away as part of a broader negotiation.
While we can conjecture all we want, over the next several weeks, up to and including the late June G-20 talks, ebbs and flows in trade talks are likely to be front page news and market moving. But unless the overall economic outlook changes materially, market changes are likely to be contained. When the S&P 500 crossed 2900 in April, it reached its outer band in terms of valuation. Said differently the 25% rally from Christmas to the end of April basically took away most bargains. Thus, we have a buyer strike in May. There are always reasons to sell; markets move up when there is some urgency to buy. With valuation removed, growth showing signs of slowing, and trade tensions rising, the path of least resistance is lower. That can all change if prices fall too much, if growth reaccelerates, or trade tensions ease.
Moving to Britain, overnight Prime Minister Theresa May announced she would resign on June 7. All the leading candidates to succeed her are Brexiteers. With that said, the EU is not in a mood to renegotiate the deal made with Ms. May. That doesn’t mean there could be a few tweaks, but a broad change in Britain’s favor is unlikely. What does change is the odds of a hard exit come October should the new PM not have the strength to develop a coalition to support a compromise deal. Ms. May clearly lacked the political power to build any sort of compromise. The British pound had fallen for 14 straight days in anticipation of her resignation and increased odds of a hard Brexit. Now all await her successor and any possible change in course of action before the new October Brexit deadline. While Brexit won’t have the economic impact of a trade truce with China, it is another modest negative to add to those already in place.
As the negatives pile up, it is easy to get too nervous. Adjusting to modestly slower growth is fine, but a modest slowdown in growth isn’t a repeat of 2008. One of the hallmarks of true financial collapses like 2008 is that they stay in our brain for a very long time. Your parents and grandparents still behave with thoughts of the Great Depression in the backs of their mind. Caution is good but excessive worry is not. The economy is somewhat like a rolling hillside. There are uphills and downhills but nothing threatening to stop the journey. Mid-course corrections happen as a matter of course. Yes, there exists the possibility of an all-out trade war, but it would seem, at least to me, a somewhat illogical 12-18 months before a Presidential election. If Mr. Trump wants to play serious hardball, that should be a second term action. Even then, a President who views the stock market as his scorecard, isn’t likely to create a recession where none exists. Thus, markets might drift lower into earnings season, but any serious decline approaching 10% in total should bring bargain hunters back. Low interest rates also push investors toward bonds. One reason safe stocks like utilities, REITs, and consumer staples are acting so well despite valuations that seem excessive based on history is that low bond yields are driving income seekers to these stocks. That isn’t likely to change until rates start moving back up.
The stocks getting hurt the worst are those with strongest ties to China. Obviously, news headlines will be most meaningful to them. Some are even approaching bargain levels although it still may be early to step in. Nibbling might be a better course. In the meantime, stay calm, set your shopping list, and don’t worry about easing in as stocks climb a wall of worry. We are not in for a repeat of 2008.
Today, Patti LaBelle is 75. Bob Dylan turns 78.
James M. Meyer, CFA 610-260-2220