May 22, 2018

The stock market as a whole struggled last week, giving back some hard-fought gains of the prior week’s advance, with the S&P 500, Nasdaq, and the Dow losing between 0.5% and 0.7%. However, shares of smaller, domestically-focused companies that are less affected by a rising dollar outperformed, sending the Russell 2000 1.23% higher, closing at a new record high in each of the last three sessions of the week.

While stocks have made a nice comeback from a crucial technical test of the 200-day moving average, there are some clouds forming on the horizon that I see as potential obstacles. A lot of attention is being given to the U.S.-China trade talks where some progress was made over the weekend with China agreeing to buy more U.S. goods to narrow the gaping trade deficit that was a record $375 billion in 2017.

Chinese trade officials, however, would not commit to a hard dollar figure on how much more they would import and over what period of time. As such, I chalk this up as a victory for China, because the threat of tariffs is essentially lifted. China can claim they made concessions on imports, which they can string out for years. Any time trade officials come away saying, “We’ve made meaningful progress” or “We agreed on a framework” without any numerical specifics, then I view it as a deal without much substance.

Speaking of empty deals, House Speaker Paul Ryan set a May 17 deadline for the Trump administration to submit a new NAFTA deal with Mexico and Canada to Congress for approval. That deadline has now come and gone. After nine months of negotiations, U.S. officials said that the three nations are nowhere near a deal on NAFTA. So, it now looks like any new NAFTA deal will fall on next year’s Congress.

In other international developments, the U.S. pullout from the Iranian nuclear deal is pushing oil prices higher and Kim’s stonewalling about the June 12 summit in Singapore is raising concerns that North Korea is not serious about striking a deal on denuclearization. According to U.S. officials, North Korea has already failed to abide by some of their commitments in the “Panmunjom agreement” that was signed on April 27 at the inter-Korea summit between North Korea’s Kim Jong-un and South Korea’s Moon Jae-in. The negative change in the Korean narrative is disappointing, but not unexpected.

As far as geopolitics go, these situations certainly deserve investor consideration in assessing whether any news is good enough to lift the market or bad enough to provoke any real downside risk. For now, the market is content giving the benefit of the doubt to the notion that cooler heads and rational dialogue and negotiation will prevail. We can see this in the persistently benign level of the volatility indicators.

A Trifecta of Macroeconomic Headwinds

Beyond this mix of potential market-moving headlines, however, I see three other areas of concern as fundamental risks to the market’s near-term uptrend. They would be (1) the strong dollar, (2) spiking oil prices, and (3) rising interest rates. This could be a trifecta of trouble if they all continue to trend upward in a coordinated fashion. A stronger economy warrants higher energy prices from rising demand; a rising dollar computes when considering that the Fed is shrinking its balance sheet, and rising interest rates make sense when the Fed is tightening its fiscal policy after nearly a decade of financial stimulus.

Crude oil has been touching levels last seen over three years ago as global supplies tighten amid fears over the implications of the Iran nuclear accord break-up. As of last Thursday, North Sea Brent traded at $80.00/ bbl., while WTI crude hit $71.50. The summer driving season officially kicks off Memorial Day weekend, just a few days away. Average gasoline prices across the U.S. are fast approaching $3.00 per gallon, which is a serious budget item to contend with for many Americans who commute long distances.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary

A sharp 5% rise in the U.S. Dollar Index in the last month will surely show up as a foreign exchange headwind to profits for most multinational companies when they report Q2 earnings. Here too, companies have enjoyed Goldilocks conditions for so long that the market may react negatively if the dollar continues to climb. And from a technical standpoint, it looks very much like it will. The U.S. Dollar Index (DXY) currently trades at 93.66 with overhead resistance at 95. A move through that level opens the way for a further rally to 100, a level which would be very problematic for companies doing more than 50% of their business overseas. This explains the pronounced rotation of late into domestic small- and mid-caps stocks by professional fund managers seeking to lighten up on multinational stocks.

And while rising oil prices and the bullish move in the dollar are more apt to be curtailed by new crude supplies hitting the market and central bank injections to stem further price increases, there is little the market or outside forces can do to slow the rise in bond yields if the market senses inflation and a hawkish Fed. This is where I see the current rally running into some volatility as we approach the next Federal Open Market Committee (FOMC) meeting on June 13. There is currently a 95% probability the Fed will raise Fed Funds by a quarter point to 1.75%-2.00%, according the CBOE FedWatch Tool site.

Graphs are for illustrative and discussion purposes only. Please read important disclosures at the end of this commentary.

Such a move would be the second hike this year, with Fed Chairman Jerome Powell openly suggesting there could be four rate hikes in 2018. That would imply a third rate hike in September and a fourth in December. With the domestic GDP expanding at a 3%+ clip, inflation ticking higher, and second-quarter corporate sales and earnings growth looking to exceed that of the first quarter, the market being a forward discounting mechanism will spend the next few weeks weighing out the forces of rising wages, business investment, and consumer spending against higher costs to operate businesses and higher interest rates.

To that point, I think the market can transition through these eventualities, but not without some bouts of volatility along the way that will test the mettle of investors – similar to what occurred during February and March. Essentially, I do not expect a smooth ride for the stock market during the summer months, but I believe investors should maintain a cautiously optimistic stance on how they manage their portfolios.

Stock picking is always a paramount concern, and there is always a bull market somewhere, but heading into the summer, it’s my view that stock selection – like beach-front property – will come at a premium.

About The Author

Bryan Perry

Bryan Perry
SENIOR DIRECTOR

Bryan Perry is a Senior Director with Navellier Private Client Group, advising and facilitating high net worth investors in the pursuit of their financial goals.

Bryan’s financial services career spanning the past three decades includes over 20 years of wealth management experience with Wall Street firms that include Bear Stearns, Lehman Brothers and Paine Webber, working with both retail and institutional clients. Bryan earned a B.A. in Political Science from Virginia Polytechnic Institute & State University and currently holds a Series 65 license. *All content of “Income Mail” represents the opinion of Bryan Perry*

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