The past week has been a tough one for stock investors. The S&P peaked on July 26, and it has dropped every day since then for a total decline of almost 6 percent (as of the close of August 3). This is a large and fast drop that has understandably rattled investors, who wonder why the sudden pullback—and whether it will continue.
Trade War Moves Into Hot Zone
The drop was triggered by a renewal of the trade conflict between the United States and China. The United States ratcheted up the conflict by threatening to impose a new range of tariffs of 10 percent on $300 billion of imports from China. China retaliated by canceling orders of U.S. agricultural goods and allowing the exchange rate for its currency to drop below 7 against the U.S. dollar for the first time ever. The market had largely grown used to U.S. threats, but the Chinese retaliation is a new element that has threatened to take what had been a cold trade war into the hot zone. Such a hot trade war would meaningfully threaten corporate earnings by causing lower sales and higher costs around the world.
Given this, the cause of the pullback is clear: corporate earnings will be threatened, and as stock prices depend crucially on those earnings, prices have pulled back. With sales to China potentially down and with costs rising as companies relocate their supply chains to more expensive areas, a 6 percent drop in earnings is certainly possible. In that sense, the size of the pullback makes sense, as it reflects a reasonable estimate of the potential earnings damage. The speed of the pullback also makes sense, in that the causes—U.S. policy and Chinese reaction—took place over a period of days, just as the pullback did.
Looking at the recent pullback this way, we can see it not as some bolt out of the blue but as a rational reaction to changes in policy and the subsequent economic impact. With this understanding, we can also draw some conclusions about what likely comes next.
Markets Reacting Rationally
First, markets are indeed reacting rationally. There is a clear connection between what is happening in the news, what it means for corporate earnings and what happens to stock prices. Markets are reacting as they should.
Second, we may see more volatility. As the United States and China duel back and forth on policy, the markets will keep responding to that new information. If earnings look likely to get hit, we could see more of a decline. On the flip side, markets are also likely to respond if policy looks to be less damaging. If, for instance, the United States and China cut a deal or even agree to keep talking, we could see a recovery. This recent drop is not necessarily the start of a larger decline but a response to circumstances—which could go either way.
The Good News?
The good news is that a deal should be reachable. The United States made its point with the tariff announcement, while the Chinese have now made theirs with the agricultural order suspension and currency manipulation. These are likely both negotiating tactics, rather than a determination to start a trade war. We have seen this kind of back-and-forth before, although at a lower volume, and the result has been a deal. An agreement remains the most probable result this time, in which case we could see a recovery in both expectations and stock prices.