Last week, the abrupt change in trajectory in US-China trade negotiations was a stark reminder that the strategic trade policy differences between the world’s 2 largest economies are not easily overcome.
Instead of making progress on a trade deal, the US announced plans to increase tariffs on Chinese goods. Early this week, China announced a retaliatory round of tariffs on US goods, causing another move down and higher volatility for stocks.
About the expert
Jurrien Timmer is the director of global macro in Fidelity's Global Asset Allocation Division, specializing in global macro strategy and active asset allocation. He joined Fidelity in 1995 as a technical research analyst.
Before these recent moves, markets seemed to be expecting a deal, and stock prices reflected those expectations. The sudden move towards higher tariffs was an unwelcome development for a stock market sitting at modest new all-time price highs and a forward price-to-earnings multiple of 17.1x.
So far the S&P 500 has declined about 5% from its May 5 all-time high of 2,954 to Monday's closing price of 2,811. That’s not too surprising, considering the meteoric 26% rise from 2,347 since December 26 and that a full resolution of trade issues was all but priced in. But elsewhere, the damage has been more severe. Emerging market stocks are down 9%, based on the MSCI Emerging Markets Index, and the Chinese yuan (CNY) is down to 6.88 against the USD.
Will China stop buying Treasuries and let the CNY go below 7.0? I doubt it but this has become a high stakes game. It reminds me of the whole Brexit debacle, which is still unresolved 3 years after the UK referendum.
Another disturbing development is the sudden move to new lows by the CRB Raw Industrials index (to 468). This index has been a good proxy for the global economy. My base case assumption has been that global growth was bottoming now that China is reflating in earnest. It’s still my base case but I have less conviction.
The bond market shows caution signals
The bond market has taken notice of all this and is pricing in more Fed rate cuts than it was doing already. Until last week the Fed Funds curve was pricing in 1½ rate cuts over the next 2 years (with a 2021 Fed Funds rate of 2%), but now seems to expect 2 rate cuts (with a 2021 Fed Funds rate of 1.88%). With that, the 3-month/10-year yield curve has flattened again, although the slope was still (barely) positive as of Friday. The bond market is clearly putting the Fed on notice that if trade tensions do not get resolved, the Fed will need to step in and take its recent change in policy direction to the next level. I had assumed that the Fed was going to be out of the picture for a long while, but perhaps not.
Earnings may take longer to recover
On the earnings front, while the first quarter (Q1) is significantly beating expectations, it is looking more and more like the path of earnings growth will less resemble a V and look more like a U. While Q1 earnings-per-share has swung from a -3.9% contraction rate a few weeks ago to +0.6% growth as of last week, Q2 is now down to -1.9%, and the recovery after the first half is looking less robust. The Q4 growth rate of +15.0% is down to +9.5%.
Uncertainty weighs on valuations
So what does it all mean? In a situation that is this fluid (trade, the Fed, earnings), valuation is the first and last transmission mechanism for uncertainty. For the recent 17x multiple to be justified, basically everything needs to go right, and clearly that is not the case right now. The S&P 500 P/E ratio (using estimated earnings for the next 12 months) is down 0.4 points from its recent high of 17.1x (to 16.7x). It’s a good start but I wonder if it’s enough.
So the next question is: what is the right multiple? 16x? 15x? Last December, the multiple bottomed at 13.6x (after peaking at 19.5x in January 2018). I doubt we will get that far, but at this point we have only retraced 11% of the rally in valuation terms. If trade tensions escalate from here, investors may demand more of a concession, and that could mean more trouble for stocks.
To give you an example, since the Brexit referendum in June 2016, the UK stock market has done OK, earnings are up 30% in 3 years, but the P/E ratio has declined from 16x to 11x. That’s the price of uncertainty. I don’t think we will see the same valuation erosion in the US, given the much better fundamentals here, but directionally we could see a similar story unfold, if trade tensions continue to escalate.
The other factor that is likely to support the US stock market is my thesis that US stocks are actually much cheaper than they appear. If you look back at the S&P 500’s P/E since 1900, the index recently traded around the 85th percentile, which is another way of saying that stocks have been more expensive than today only 15% of the time. But if we consider the total cash yield—dividends plus buybacks—that investors are getting from stocks, the current 5.2% cash yield ranks only at the 28th percentile (meaning the market has been more expensive 72% of the time). This tells me that there is less downside risk for valuations in the US than would otherwise be the case.
What should investors do?
In times of volatility, it makes sense to know what kind of investor you are. If you are a long-term investor with a solid financial plan, you should have an investment strategy built around your timeline, risk tolerance, financial situation and goals. If so, you don’t need to worry about each market move or development in the new cycle.
If you are a more active and tactical investor, you may want to consider managing risk with investment-grade bonds, and watching for a buying opportunity as the situation evolves. That could involve emerging market stocks, debt, and US stocks.
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