Stocks Have Not Priced In The Trade War

At a Glance

  • Without an end to the U.S./China dispute, equity indexes may not stay at current levels
  • Earnings remain the final domino in the trade war relationship with stocks

The United States/ China trade war has been a leading story in financial news for over a year. President Donald Trump signed a proclamation on March 9, 2018 authorizing tariffs on imported steel and aluminum from all nations, including China.

Leaving allies of the United States some room to negotiate, it was clear the real target of these tariffs was China. Weeks later, on March 22 the U.S. proposed tariffs in response to China’s “unfair trade practices” related to technology, intellectual property and innovation transfer, saying it would complain to the WTO, which happened the very next day, and look at restricting investment from China.

Choppy Equity Markets

It was then that China unveiled tariffs on $3 billion of U.S. imports which they claimed was “in response to” steel and aluminum tariffs and the trade war was on. From the high print on March 13 to the low print on April 4, NASDAQ futures fell 12.5 percent. Over similar time periods, the S&P futures fell 8.8 percent and the Dow Jones futures dropped 8.5 percent.

The equity markets remained choppy for about another month, but then resumed the bull market run until early October, when Fed Chair Jerome Powell said in early October that rates remained a ”long way” from the neutral level.  He loosely defined the neutral level as the level that will neither speed up, nor stall economic growth and said that the Fed could ultimately raise rates beyond that neutral level. Combine that with a very active month for anti-China rhetoric out of the U.S., and anti-U.S. rhetoric out of China and you get an end-of-the-year mini-bear market.

The Fed Pivot

Fast forward to April 2019 and the bull is back. The Fed bestowed upon the markets their now famous “pivot” which took them from a hawkish stance with more rate hikes to come, to a dovish stance where no rate hikes are priced in and some are saying a rate cut is possible, all over the course of two FOMC meetings. A U.S./China tariff truce is still in place and most of the trade-talk rhetoric is positive and pointing to an imminent deal. The question now becomes, with NASDAQ, the S&P 500 and the Dow all back near their all-time highs, have the markets priced in too much optimism?

Economic data has been decidedly weak in China and the EU and mixed in the United States. S&P 500 earnings for Q4 2018 came in at 13.1 percent, coming in lower than the previous quarter for the first time since Q4 2017. According to FACTSET the estimated earnings decline for the S&P 500 in Q1-2019 is 3.9%. This would be the first negative earnings growth for the index since Q3-2016. The previous four quarters earnings growth look like this:

Q1 2018: 15.11 percent

Q2 2018: 17.75 percent

Q3 2018: 21.77 percent

Q4 2018: 13.1 percent

The Trade Effect on Earnings

The trade war was ramping up and getting progressively worse throughout 2018, but the blended earnings growth rate rose in Q2 and Q3. This is evidence of the time it takes for these things to make their way to the core of what moves stock prices: earnings.

There is currently no trade deal in place, but equities trade not only like there is a deal, but like we already know the details of the deal and that the details are bullish. It stands to reason that once a deal is finally done, that it will take a similar 2-3 quarters before the positive impacts of the deal make their way through to sales and earnings growth.

Then there’s the US/EU deal to work on, the issue of ratification of the USMCA by a now divided Congress. Stocks should be higher than they were at the end of December 2018 just based on the Fed pivot, but without an end to the trade war and a turnaround in earnings growth, stocks have priced in far too pretty of picture. I guess one out of three ain’t bad.

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