May 17, 2019 – This week’s nearly round trip in stock markets serves as yet another reminder that it is incredibly difficult and misguided to try to predict short-term movements in the financial markets. After a steep -2.5% drop in the S&P 500 on Monday, in response to an escalating trade war between the U.S. and China, the market clawed its way back and was set to close flat on the week as of Thursday afternoon.

Presumably, this rebound in the market was in response to some solid earnings reports from companies like Walmart and Cisco Systems, Inc., signs that talks between the U.S. and China had not been completely derailed, and evidence from the Trump administration that it would temper trade fights with allies, including Mexico, Canada, and Europe. (Specifically, U.S. trade negotiators have discussed removing metals tariffs on Mexico and Canada while also announcing a 180-day delay in any potential announcement to tariff auto imports.) However, on Wednesday, President Trump signed an executive order enabling the U.S. to ban telecommunications network gear and services from “foreign adversaries,” while also adding Chinese telecommunications darling Huawei to its “Entity List” that would require any U.S. company to obtain a license before selling technology to Huawei. Though the executive order did not single out China, the moves represent a pretty direct escalation of the trade war via non-tariff means.

Investors appear to be struggling with how to re-price both the probability of a prolonged escalation of trade tensions between the U.S. and China and the potential impact on the global economy. So far, it appears the market is continuing to price in an eventual deal under the “cooler heads will prevail” scenario, seeing optimism in the likelihood of President Trump and President Xi meeting in person at the G20 summit at the end of June. However, we believe a degree of caution is warranted. It is true that a meeting between the two leaders is critical, but in our view, that meeting is critical not to seal a deal but rather just to get negotiations back on track. Up until the beginning of May, we had been of the view that the two sides wanted to reach a deal and would do so within a relatively short timeframe. We believe two important developments make that a more difficult feat:

  1. The Chinese have made it pretty clear, in our view, that they are not keen on making structural changes to their laws to protect intellectual property and stem subsidies to state-owned enterprises.
  2. With the Trump administration acknowledging that an agreement without teeth will not be acceptable, he is taking the fight public, making it challenging to now accept an agreement that does not include these important changes to Chinese law. He also has a remarkable amount of bipartisan support from Washington and the business community to fight this battle—though many within that group disagree on using tariffs as the negotiating tool.

Because of this, we think the spell has been broken, and investors should be cautious about any further efforts from the Trump administration to talk up the market with comments about “productive” or “constructive” negotiations.

Figure 1. Values of U.S. tariffs proposed and imposed

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Data as of May 11, 2019.

Source: Goldman Sachs.

Core narrative 

The U.S. economy remains on solid footing, and the global economy appears to be stabilizing. But subsequent rounds of tariffs could begin to have negative compounding effects on consumer and business confidence and spending that are not fully appreciated at current stock market valuations. We expect a period of heightened volatility as trade tensions remain high for a prolonged period and global economic data mixed. Last week we took steps to mitigate risk in portfolios. First, we reduced our overweight positions to U.S. Large-Cap and Emerging Markets Equities to neutral. To be clear, we are recommending that clients remain invested; we just no longer feel it appropriate to hold more exposure to equities than our long-term strategic benchmark. We have also reduced cyclical exposure within our equity sector strategy by reducing allocations to those sectors most tied to economic growth, including technology, consumer discretionary, and industrials. The proceeds were used to increase our allocation to defensive sectors including consumer staples and utilities, which tend to outperform the broader market in periods of stress.

We will continue to monitor trade developments and economic data, prepared to adjust portfolios should conditions warrant.

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