As of May 21, 2019
- United States stock prices rose over +4.0 percent in April.
- First quarter earnings beat very low expectations.
- The United States intensified its trade fight with China.
- Risk assets are vulnerable if trade tensions deteriorate further.
- On the other hand, fundamentals are solid and could support further upside if trade tensions ease.
- Investors should ensure they are comfortable with their current holdings and continue to focus on investments that align with their goals.
Data Source: FactSet
Two boxes checked and one significant question mark
Last month, we set forth three essential requirements to keep stock prices trending higher through the second quarter. Those ingredients boiled down to:
- Investors needing to see an improvement in economic data
- Better-than-anticipated first quarter earnings reports; and
- A U.S./China trade deal
We can check the first two boxes, but the third remains a major uncertainty.
What boosted the markets?
In the first quarter, U.S. Gross Domestic Product (GDP), the measure of the nation’s economic growth, accelerated at a surprising 3.2 percent annualized rate. Meanwhile, the unemployment rate dipped to 3.6 percent in April, as the economy added 263,000 new jobs. The labor market is as good as it’s been since the 1960s, which we believe supports a healthy American consumer with the ability to move growth forward. Put a “check” in the box next to the first ingredient.
On the corporate earnings front, first quarter earnings season is nearly complete. Importantly, U.S. companies have exceeded analysts’ expectations for profits both on an earnings per share (EPS) and sales basis. With almost all of S&P 500 first quarter 2019 earnings reports in, the EPS growth rate is down just 0.5 percent year-over-year. This is encouraging as analysts projected a nearly 4 percent decline in EPS growth heading into the reporting season. When it comes to sales, which we believe are a better indicator of underlying corporate health, S&P 500 revenue rose 5.3 percent year-over-year. Mark a “check” in the box next to the second ingredient.
With U.S. economic data strengthening and corporate profits coming in better than anticipated, the S&P 500 Index was able to post an 18 percent year-to-date gain through the end of April — its strongest start to a calendar year since the 1980s. Considering the stable fundamental backdrop, this broad-based stock benchmark also recently surpassed its previous all-time high set in September and was looking to stretch gains into unchartered territory at the beginning of May.
That said, rising trade tensions with China essentially poured cold water on these favorable scenarios and turned the focus back to the potential economic risk that could result.
The U.S. increases tariffs on China imports
As we entered May, many investors expected the U.S. and China would soon ink a trade deal. However, those expectations were dashed when the U.S. increased the tariff rate from 10 percent to 25 percent on $200 billion in Chinese imports. In our view, this could increase the risk of an all-out trade war between the two countries. Even if we avoid that, it represents at least a messy next step in the process of reaching a workable agreement for both countries. Here’s what you need to know from a market perspective:
- The trade fight could get worse before it gets better. China retaliated with $60 billion in tariffs on more than 5,000 U.S. imports starting on June 1 and could make it more difficult for U.S. businesses to operate in China. Perhaps, Beijing may also choose to devalue its currency over time to mitigate the effects of U.S. tariffs. Consequently, the White House is already preparing another round of tariffs that, if implemented, would essentially place a tariff on all Chinese imports to the United States.
- Expect markets to react in unpredictable and potentially volatile ways. At this point, it is impossible to forecast how trade talks will develop with any degree of confidence. Therefore, investors should expect risk assets to be more sensitive to trade-related headlines, and we could see downside pressure if discussions devolve.
- Further escalation in tariffs puts global growth at risk. If global growth slows more than expected this year due to rising tariffs, it most likely means global corporate profits will slow more than expected as well. If this happens, investors are likely to pay less for those future earnings streams — hence, stock prices could decline in such a scenario.
The current bull market has proven remarkably resilient and has weathered many uncertainties over the last decade. Though trade frictions should eventually pass, their weight on growth and the degree of unpredictability they add to the markets leave investors rightfully unsettled.
In our opinion, trade tensions represent the most direct geopolitical threat to growth and profits this market has faced since the 2008 financial crisis. Yet, we still believe the U.S. and China can eventually work out a trade deal. Simply put, it’s in the best interest of both countries to find common ground, which makes a deal the most rational option. For the bull’s sake, let’s hope both countries find agreement sooner rather than later.
A good time to see where you stand
Be sure to talk with your advisor about how your portfolio is currently positioned and whether any adjustments are needed to address potential market swings going forward. While underlying economic fundamentals remain stable, “wild card” issues like trade wars can add a degree of unpredictability to the markets.
Data source: Morningstar Direct
As of May 13, 2019