Trade fears began to pummel the equity markets this week after President Trump indicated he will impose a deadline of this Friday for a trade agreement with China or tariffs will increase from 10% to 25% on $200 billion worth of Chinese goods. According to Reuters this shift in tone came after US Trade Representative Robert Lighthizer informed President Trump that Chinese negotiators were seeking to deal with policy changes through administrative and regulatory actions, not through changes to Chinese law as previously agreed. A person close to the negotiations indicated that under China’s system — in which the Communist Party has ultimate control — changes in law are the only way to get even a small measure of certainty on compliance. From this perspective, it should not be surprising that President Trump is playing hard-ball with China. A weak or ineffective trade deal with China may not be any better than no deal at all.
China versus US
With a trade deal now in doubt, stock and oil prices declined and bond prices rose. As seen on page 16, over the last five trading days the SPX fell 1.4% but the Shanghai Composite index sank 5.2%, or nearly four times as much as the SPX. The DJIA suffered a 473.39 point, or 1.8% drop on Tuesday, its largest one-day sell-off since January 3 and the SPX fell 1.7%. Nevertheless, the broad indices are less than 2.5% away from their record highs and the current declines are barely visible in long-term charts. In our opinion, the disparity in the performance of the Chinese and the US equity markets is important since it is a reflection of the potential impact tariffs are likely to have on the respective domestic economies.
Given the drama seen in the markets this week we thought it best to bullet point some thoughts:
- President Trump currently has a timely and stronger hand in terms of negotiating with China after the 3.2% GDP growth rate reported in 1Q19 and the record highs recorded by the equity market. Negotiations over intellectual property rights are crucial to a good trade deal.
- Dramatic moves in the stock market tend to be counter-cyclical; that is, major tops tend to be slow and pondering, whereas corrections tend to be sharp and dramatic. The current decline has the earmarks of a correction to the major move.
- A 600-point intra-day decline in the DJIA is intense and tends to bring out bearish commentators however a long-term chart is needed to put the recent 2.5% decline in perspective after the 25% gain seen from the December low. See page 11.
- In early April first quarter earnings growth was estimated to decline 2% YOY, but with roughly 85% of the SP500 now reported, IBES Refinitiv consensus currently shows a 1.5% YOY gain in 1Q19 EPS. This gain may not be strong enough to generate a sustainable advance, but it is nevertheless much better than anticipated. The gain is 2.5% excluding the energy sector.
- Trade contributed to the 3.2% GDP growth rate in 1Q19. Since there was a considerable amount of pre-buying as tariffs were about to go into effect in 2018, 2019’s first quarter could reflect the longer-term impact of the current trade tariffs. And we noted earlier, trade tariffs are negatively impacting US farmers, but agriculture contributes less than 1% to US GDP.
In sum, we do not believe a failed trade negotiation with China will trigger a substantial decline in US equities. Conversely, a successful trade agreement should propel the indices back to their recent highs. There is no change in our SPX 3110 target for this year and we continue to believe our target could prove to be conservative.
Strong Economic Numbers with a Few Weak Undertones
Not only was April’s 3.6% unemployment rate the lowest level reported since December 1969, but the 1.9 million people who applied for unemployment insurance in the last five weeks was the lowest since the 1.8 million seen in January 1970. See page 3. These are signs of a strengthening job market. Non-supervisory hourly earnings rose an inflation-adjusted 1.9% YOY in April, well above the 10-year average of 0.8% YOY. Inflation-adjusted weekly earnings were up a similar 1.6% YOY and were also above the 10-year average of 0.8% YOY. See page 4. Still, April’s confidence indices remain below peak 2018 levels. Confidence may improve as households experience the benefit of rising wages and modest inflation. The sum of inflation and the unemployment rate is often called the Misery Index, and this index was 5.2% in April, the lowest since September 2015’s 5.0%. See page 5.
The preliminary estimate for 1Q19 GDP growth was 3.2%, and despite a government shut-down and poor weather, it was substantially better than the 2.2% pace seen in 4Q18. This improvement came despite a slowdown in consumer spending which was not a surprise given recent retail sales numbers. Inventory accumulation increased as expected since inventories declined at yearend. Growth in fixed investment slowed. Real disposable income growth slowed to 2.4% from 4.3%. The saving rate rose to 7%, from 6.8% in the fourth quarter. However, we found the improvement in the trade deficit to be the most encouraging aspect of the quarter. See page 6.
The current expansion is only a few months from becoming the longest in history, yet this economy is not showing the excesses typical of an aging cycle such as rising inflation or gross private domestic investment generating 19% or more of GDP growth. See page 7. In fact, we see pockets of weakness. A 3-month average of retail sales, adjusted for inflation, rose 1.1% in April, the slowest pace since emerging from a recession in 2009. Residential investment rose 0.6% YOY in 1Q19, the lowest since 2011; and as a result, residential investment represented only 3.76% of GDP growth. See page 8.
A number of economists are fearing there will be higher inflation and weaker profit margins due to rising wages. However, we disagree. The employment cost index (ECI) in the first quarter showed total compensation rose 2.8% YOY and wages declined from 3.1% YOY in 4Q18 to 2.9% in 1Q19. Private industry compensation costs were even milder at 2.7% YOY versus government total compensation costs at 3.0% YOY. Union worker total compensation costs rose 3.4% YOY in 1Q19 versus the 2.7% seen for non-union workers. However, we are focused on the private industry costs of 2.7% YOY which are quite benign when compared to the first quarter CPI rise of 1.9% YOY. See page 9. All in all, we believe the US economy is demonstrating solid growth but is still growing below its potential.
The recent sell-off is barely visible in the charts seen on page 11 and most indices remain near all-time highs. However, the Russell 2000 has been lagging and is the only index with a down-trending 200-day moving average. This underperformance is in stark contrast to our NYSE cumulative advance decline line which recorded a new high on May 3. We will be monitoring the RUT during market weakness and as it tests its 200-day moving average. Holding above this level would be an encouraging sign of strength. The 25-day up/down volume oscillator is at 0.06 (preliminarily) this week despite the recent sell-off. The oscillator made a two-day overbought reading on April 11-12 and April’s reading followed a long 25-consecutive-day overbought reading in January through March. The 10-day average of daily new highs is 189 and above the 100 per day level defined as bullish. The A/D line made a new record high on May 3, 2019 and is also positive. We remain long-term bullish.
“Overweight”: Overweight relative to S&P Index weighting
“Neutral”: Neutral relative to S&P Index weighting
“Underweight”: Underweight relative to S&P Index weighting
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