In our recently posted Mid-Year Market Outlook,Clearing the Path, we stressed that the U.S.-China trade dispute was the single biggest risk facing investors in the second half of the year and beyond. In light of the events of this past week, we are now clearly seeing that risk playing out. Following the latest volley of actions lobbed back and forth between the two countries over the past several days, the Dow Jones Industrial Average and S&P 500® are now down 6% from their record highs of late July, and the NASDAQ has fallen more than 7%. In addition, the 10-year U.S. Treasury yield has dropped to 1.72%, its lowest point since October 2016.
The White House on August 2 imposed 10% tariffs on an additional $300 billion of Chinese imports to take effect September 2. This has brought the total tariff count, including retaliatory tariffs by China, to more than $650 billion. In reaction, China took more actions over the past weekend, including letting the yuan fall below 7 per U.S. dollar (a level not seen since 2008). As a result, on August 5, the U.S. Treasury Department formally labeled China a currency manipulator, a mostly symbolic status not bestowed upon the country since 1994.
In addition, China halted the importation of U.S.-produced agricultural products believed to be worth about $24 billion annually. This has further increased speculation that the next step in this battle might be for the U.S. to increase the recently announced 10% tariffs up to 25%. Taking all of this into consideration, one might say this trade dispute has clearly elevated to trade combat.
With this backdrop, we would like to reiterate the following points:
- The market volatility we have seen this past week could well continue until U.S.-China trade negotiations get back on the rails. Admittedly the rhetoric seems far from conducive toward getting amicable discussions back on the calendar. However, we would remind investors this in many ways remains a fluid situation.
- As we also mentioned in our Mid-Year Outlook, the market will likely be focusing on two factors: time and escalation. How long might these trade hostilities go on and, in the process, how much might both sides raise the stakes of the conflict? Unfortunately, this past week has increased investors’ angst on both counts.
- As we also stated in the Mid-Year Outlook, we believe an unresolved trade dispute into 2020 could negatively impact U.S. economic growth by approximately 0.50% but is unlikely to lead to a recession. While U.S. corporations appear to be holding back on capital spending in large part based on trade uncertainties, U.S. consumer spending has remained strong. As the latter group represents about two-thirds of gross domestic product growth, we continue to watch that trend closely.
- The escalation of the past week has also increased expectations that the Federal Reserve will deliver on more rate cuts between now and year end. While there was originally some reticence as to how much further the Fed might ease following the July 31 Fed Funds reduction of 0.25%, it now appears as though the market anticipates policy activity quite close to the mini-easing cycle we forecast in our Outlook. Specifically, as of the close on August 5, Fed Funds futures were pricing in better than a 90% probability of 50 basis points more in rate cuts by year end and about a 60% probability of 75 basis points.
Despite this escalation, we believe opportunities remain within the equity or credit markets based in large part of the following:
- Expected rate cuts by the Fed will likely provide some floor to the immediate selling and a buffer to the economic impact of the trade hostilities as we could see a Fed Funds target rate of 1.25%-1.50% by year end.
- Long-term bond yields, in our opinion, are also pointing toward opportunities in U.S. stocks. With the S&P 500 dividend yield now eclipsing the 10-year Treasury (1.97% vs. 1.72%), there is an increasing valuation argument for U.S. stocks assuming they can continue positive earnings growth into 2020, which we believe they can.
- Globally speaking, long-term government bond yields are negative in many regions of the world. For instance, the Japan 10-year stands at -0.21% and the 10-year German Bund is at -0.51%. We believe these historically anomalous yields will help to highlight the comparative income and total return propositions of U.S. stocks.
- The equity risk premium on U.S. stocks is potentially signaling a strong entry point. With an earnings yield of approximately 5.4% on latest twelve-month profits, subtracting the 10-year Treasury yield of 1.72% leaves a differential of approximately 3.7%, which by historical standards has proven to be opportunistic for long-term investors.
- High-yield credit spreads, while having increased over the past week, are still below their year-to-date highs of early June, potentially signaling that fundamental credit conditions have not materially shifted despite the selloff in stocks.
- The overall trade situation remains an evolving one, and given the political environment heading into the 2020 election, negotiations could pick up again, perhaps in the fourth quarter after additional rate cuts have been implemented by the Fed.
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