The period of January through April marked the best four-month start a year for stocks in more than 30 years, but markets have hit a rough patch in May on fears that a U.S.-China trade conflagration could morph into a full-blown war.
Investors and strategists tell MarketWatch that heightened uncertainty over U.S.-China trade relations will continue to be a significant headwind for equity benchmarks, but that the extent of the damage could be limited by both the Trump administration and the Federal Reserve’s sensitivity to a market sell-off.
“Before last week we were pro-risk: overweight stocks, emerging markets and small caps within our stock portfolios,” Ed Campbell, portfolio manager at QMA told MarketWatch. “Now, we’ve been in the process of scaling back on those bets and going to neutral or cutting those positions in half.”
The strategy shift for wealth managers and investors follows a May 5 tweet from President Trump, who first raised the prospect allowing annual tariffs on more than $200 billion of China goods to be lifted to 25% from 10%, charging that Chinese officials reneged on commitments they had made during negotiations.
The tweet sparked a cavalcade of selling of assets perceived as risky, like stocks and crude-oil futures, sending markets mostly reeling over the following six-session span.
Indeed, the S&P 500 (.SPX), lost more than 4.5% of its value since that period. And although a rebound has taken shape on Wall Street, with the Dow Jones Industrial Average (.DJI), S&P 500 and Nasdaq Composite indexes (.IXIC), producing gains of at least 0.8% in Tuesday dealings, the tariff uneasiness lingers.
China has already announced retaliatory tariffs on some $60 billion in U.S. goods that will go into effect on June 1.
Campbell said that his caution derives more from the uncertainty these new salvos have created for U.S. businesses than the direct impact of the tariffs themselves. “The most important aspect is the impact tariffs have on business confidence, consumer confidence and financial conditions,” he said, arguing that rising tensions make it difficult for businesses to plan investment, which will lead to lower profits down the road. Meanwhile, a falling stock market will hurt consumer confidence and spending, further eroding profits and business confidence.
However, Brent Schutte, chief investment strategist at Northwestern Mutual Wealth Management told MarketWatch that investors can’t look at tariffs in isolation, because their impact on the economy will affect trade negotiations themselves, and more important, the actions of the Federal Reserve.
“The one key difference between now and the fourth quarter correction is that the Federal Reserve is a friend rather than a foe,” he said, referring to the central bank’s change in policy earlier this year from one intent on raising interest rates to stave on inflation, to one that appears set to keep rates where they are, as price growth has fallen significantly since its highs in the summer of 2018.
Schutte argued that there is “a Fed put and a Trump put to the downside,” meaning that if the stock-market reaction to rising trade tensions become too severe, the Fed will consider cutting rates to prevent a weakening stock market from suppressing business investment and consumer spending to the point that begins affecting the broader economy. A put is a derivative that confers upon the owner the right, but not the obligation, to sell an asset at a preset price and time. A so-called Fed put refers to the notion that the Fed will respond by loosening policy and providing liquidity in the wake of market turmoil.
Schutte argues that President Trump would also take his cues from equity volatility, and strike a weaker trade deal if fears that plummeting stock values will harm his reelection chances in 2020.
Institutional investors appear to agree, according to a Bank of America global fund managers survey, released Tuesday, which shows that 34% of fund managers who participated in the survey have purchased protection against a possible sharp fall in the stock market over the next three months — the largest percentage of investors buying stock-market insurance the poll’s history.
Michael Hartnett, BAML chief investment strategist, wrote in an accompanying note that investors “are well hedged, but not positioned for, a breakdown in trade talks,” suggesting that the smart-money is still betting on resolution, though those investors may see the chances of a deal as less likely than before. Meanwhile, respondents said that a decline in the S&P 500 below 2,305, or 18% below Monday’s close, would prompt the Federal Reserve to cut rates currently at a range between 2.25% and 2.50%.
Thierry Wizman, financial markets economist for Macquarie Group, wrote in a Tuesday note to clients, that the Chinese government could also respond to a breakdown in trade talks with more economic stimulus, and a “clear stimulus-minded policy tone shift could happen at the July Politburo meeting,” arguing that this prospect was “one factor helping risk taking” during Tuesday trade. China’s economy, although stabilizing lately, has been mostly showing signs of slowing and economists believe that the tariff dispute may undermine Beijing’s attempt at a soft landing.
Overall, market participants broadly view the Sino-American trade dispute as an internecine squabble that holds the potential of sinking both country’s economies, and taking the global market along for the ride.
It is unclear if either side is willing to risk an outright breakdown in talks, with the threat of global economic damage in the balance.
“There’s asymmetric risk to the downside in the near term,” said QMA’s Campbell. “If we get a deal in the next month, the likelihood is that we rally back up to the old highs, but if the deal falls apart, we could fall 10% or more.”
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