When economists studied the Great Depression after the 1930s, one of the things that was cited as worsening the economic decline and prolonging the recession was the Smoot-Hawley tariffs. This protectionist trade policy was signed into law in 1930 and raised the tariffs on over 20,000 imported goods to the U.S. Despite nearly 90 years passing since then, whenever the term “trade war” surfaces in the media, folks immediately cite the mistakes from the 1930s and warn against repeating them.
Recently the specter of trade disagreements has come into focus with Trump railing against China (and others) and determined to ameliorate what he feels are unfair trade policies that have existed for years. Trump recently announced roughly $100 billion in proposed tariffs on Chinese goods, and China announced retaliatory measures of their own. It is important to note that none of these tariffs have actually been implemented yet and can’t take effect until August at the earliest. Thus, there is plenty of time for negotiations to continue and avoid the actual tariffs as they have been discussed.
Even if the tariffs were to be implemented at currently proposed levels, they would amount to less than 0.5% of U.S. GDP. That’s a very small amount, but it is the concern that it would lead to a more drawn out trade war that is of greatest concern. We know that when losses can be quantified, however large or small, the market does a good job of quantifying the damage and adjusting to the new reality.
But what investors really hate is uncertainty; and the prospect for ongoing trade spats could add to the uncertainty and cause corporate managements to delay initiatives and stall investments that would otherwise be productive for the overall economy. So, the sooner these trade negotiations can take place, the sooner the market can price it in and move on.
The chart on the first page shows the recent pullback in the market and the increased daily volatility that coincided with many of these trade tariff headlines. But what it also shows is that despite the barrage of negative headlines in recent weeks, the S&P 500 Index did not make new lows for the year. Rather, the market held levels above those seen during the February correction. In our view, this is a positive technical development and sets the stage for a rebound in stock prices sooner than later.
Our previous newsletter described how last year was rare in terms of the lack of volatility in the stock market, and that investors should be prepared for a pickup in volatility. Most investors understood this intuitively, but once the market enters a correction it is very easy to forget one’s game plan and fall back into an irrational sense of panic. The market was overdue for a pullback such as we have seen in the last few months. But that does not mean that stocks won’t bounce again. There are still a myriad of positive fundamental drivers providing solid support for higher stock prices in the near-term.
Some of these positive factors include:
- Corporate profit growth for 2018 expected to be exceptionally strong
- Recent tax cuts should bolster strong consumer spending ahead
- Record repatriation of assets should lead to increases in dividend & buybacks
- Small business optimism remains near highs not seen since 1984
- U.S. GDP remains strong, with low probability of recession in the near-term
- Interest rates and inflation appear under control and rising slowly
- Sentiment remains positive in credit markets
- Investor skepticism is high –> ‘wall of worry’ still intact
As for the bond market, bond yields moved higher for the first two months of 2018, but have since taken a breather for the last two months. Remember, these are the bond yields set by the market, not the Federal Reserve. The bond market is focused on growth and inflation, and while the latter has firmed a bit, it has still not reached levels that would cause too much concern in the financial markets. The consumer price index (CPI) only recently hit the 2.0% mark, a level that has actually been the goal of the Fed for many years running.
Should inflation rates continue to accelerate, it would likely lead to renewed volatility in both the bond market and the stock market as well. But that is a big “if”, as inflation has been well contained for years now, not just in the U.S. but globally as well.
The chart below shows the yield on the 10-year T-note finally surpassing the 2.60% level, with the next target area around the 3.00% level (red line). If yields get there in an orderly fashion, it would be a good sign. By that we mean that it would likely be both a reflection as well as a confirmation that economic growth is on solid footing, which would be also stock market friendly.
Currently, the Federal Reserve is forecasting another two rate hikes for 2018 (again, these are hikes in short-term interest rates, not longer-term bond yields). This looks reasonable to us, and the Fed likely does not want to upset the apple cart by hiking more times than the market is currently forecasting. Inflation rates would have to really accelerate to force the Fed to hike an additional time this year.
In summary, while the trade talks have been hogging the headlines – in a negative fashion – we anticipate that at some point the strong fundamentals underpinning this market will return to the forefront and help foster higher stock prices. Investors should not let the short-term volatility that can surface due to negative headlines to derail their long-term investment goals and objectives. At some point it will again be time to adopt a more defensive posture in portfolios, but we feel it is premature to declare that time is now. For the time being, there are still many positive factors working their way into the investment landscape.
Jordan L. Kahn, CFA
Chief Investment Officer
Sources: Stockcharts.com; BTIG research; Raymond James; Briefing.com; IBD; Standard & Poors; Barron’s; Charles Schwab