Equities suffered their largest weekly decline in two years last week, with the S&P 500 Index dropping -5.9 percent.1 The market focused mainly on risks associated with ramped up tariff rhetoric, which led to fears that the United States was on the verge of entering an all-out trade war. Investors were also concerned about prospects for more aggressive monetary policy tightening and signs of economic weakness. The technology and financials sectors led the way down, with mega-cap tech stocks hit particularly hard.1 Energy companies, in contrast, fared better on a relative basis.1
Highlights
• Stock prices suffered their biggest weekly loss in two years as investors focused on several key downside risks.
• Mounting trade protectionism could represent a serious problem for the economy and financial markets, but we think the rhetoric doesn’t match the reality.
• Market fundamentals remain solid over the long term, but near-term caution may be warranted.
Are Investors Overly Pessimistic About Downside Market Risks?
While fundamentals haven’t changed significantly, volatility has picked up recently and stocks have been trading in a broad range between their early February highs and the low established in last month’s correction.1 The U.S. and global economies appear on sound footing, inflation pressures appear contained, the labor market remains strong, corporate earnings are solid and interest rates have been rising only modestly. Given this divergence between our views and market behavior, we think it makes sense to focus on why we think some risks may be overstated.
1) Trade issues are more rhetoric than reality, at least for now: Current trade issues appear to be more about appearance than actual policy shifts. True, President Trump’s steel and aluminum tariffs went into effect last week, but key trading regions were granted waivers, including Mexico, Canada, Argentina, Brazil, Australia, South Korea and the entire eurozone. Likewise, the president’s latest statements about more trade restrictions still require policy specifics.
Taking a step back, it seems that most of the trade discussion is about political posturing rather than economic reality. President Trump has essentially fired a series of warning shots at China and it is unclear what the specific follow-throughs may be, especially when it comes to trade disputes with other countries.
In reality, China would have much more to lose than the United States in a full-fledged trade war. In 2016, 23 percent of China’s exports ($480 billion) went to the United States while only 8 percent of U.S. exports ($115 billion) went to China.2 As a result, the Chinese economy depends more heavily on the United States than vice versa. We think Chinese officials will look for a win/win scenario that allows President Trump to claim a domestic political victory while doing little actual damage to the Chinese economy. And indeed, news over the weekend indicated that U.S./China trade negotiations were making progress.
The risk, of course, is that an actual trade war could be wildly unpredictable and the outcome could spin out of anyone’s control. Such a scenario could present more serious concerns for financial markets, but we peg the odds of that occurring as relatively low.
2) The United States can withstand additional interest rate increases: As widely expected, the Federal Reserve hiked rates last week and pointed to a strengthening U.S. economy. Although the Fed might increase rates slightly faster than earlier anticipated, interest rates remain historically low and remain well below a neutral level given economic growth and inflation trends. We do not believe rates will rise sharply or dramatically enough to derail the equity bull market.
3) The U.S. economy may be leveling out, but does not appear to be slowing:Relatively weak retail sales figures have led economists to expect a slight slowdown in first quarter growth.3 Other areas of the economy, such as the labor market and manufacturing, remain strong.4 This indicates to us that growth should rebound in the second quarter.