July 24, 2018

Investors are doing their level best to focus on record second-quarter earnings while letting the war on trade play itself out in the financial media. And to their credit, the Nasdaq and Russell 2000 have posted new all-time highs in the past two weeks. There is a general feeling of broad support for bringing China and other nations in line to fairer trade relationships, but it is becoming clear that this situation could play out over several months, whereas the market and many investors much prefer a quicker fix.

Apparently, China’s President Xi Jinping has no interest in talking about fair trade with the U.S. anytime soon. As per the latest reports on the tit-for-tat tariff dispute, U.S. and China trade officials have taken a pause on further negotiations, having hit an impasse. The Chinese central bank is being charged with manipulating the yuan lower to dampen the effects of tariffs and to fatten profits for exporting companies while the U.S. dollar reached a new 52-week high against the yuan and other major currencies last week.

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

Fed Chairman Jerome Powell gave a pretty upbeat report on the economy to Congress last week. That is also contributing to the dollar’s strength while pressuring crude oil, copper, gold, and other commodities. At the same time, Powell did not really weigh in publicly on the tariff war. White House Chief Economic Advisor Larry Kudlow stated in an interview at last week’s Delivering Alpha Conference that while some low-ranking Chinese officials were prepared to reach a deal, President Xi was refusing to compromise.

Specifically, Kudlow said: “I don’t think President Xi at the moment has any intention of following through on the discussion we made, and I think the president is so dissatisfied with China on these so-called ‘talks’ that he is keeping the pressure on — and I support that.”

President Trump has recently threatened to impose a new round of charges on $200 billion of Chinese products unless the People’s Republic agrees to change its intellectual property practices and high-tech industrial subsidy plans. The list comes after warnings by Trump that he may implement tariffs on at least $500 billion, which is very close to every Chinese-made imported good sent to the U.S.

Even though a trade war that could culminate in new tariffs that exceed $700 billion or more in total on a global basis, it pales in comparison to the $80 trillion global economy. It’s not even 1% of total global commerce but it could cause ripples and disruptions within the global supply chain, which is the larger risk to the stock market. News of regional manufacturing slowdowns could dampen investor sentiment.

Against this backdrop of a loud bark of trade rhetoric versus a small bite out of global growth, it shouldn’t have much of an impact on GDP, but the noise level could get to a place where market volatility spikes in August leading up to the September deadline, when the $200 billion in additional tariffs on China would begin. Looking at the CBOE Volatility Index (VIX), the most widely followed measure of short-term market volatility, the five-year chart of the VIX (below) shows the index soaring from 10 to 50 in the first week of February, 2018, fueled by none other than widespread fear of a sudden slowdown in China.

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

Since then, the VIX has tested the 12 level twice. The risk/reward proposition for getting prepared for a bout of market volatility heading into August is, in my view, notable. Once the FAANG stocks and other market favorites report their second-quarter results over the next week or two, the economic calendar will have to deliver market catalysts to offset a rising noise level of a trade war, further Fed tightening rumors, and the approaching mid-term elections, all fueled by a hyper-ventilating political and financial media.

Consider Taking Some Profits Before Labor Day

Investors will be contending with the implementation of the next round of tariffs in the first week of September, followed by the FOMC meeting scheduled for September 25-26, in which bond traders are predicting an 86.1% probability that the Fed will raise the Fed Funds Rate to 2.00% to 2.25% (see chart below). I find this level of conviction about a September rate hike interesting given the very soft housing data released this past week, when the Commerce Department announced that housing starts plunged 12.3% in June. This was the biggest percentage monthly drop in housing starts since November 2016.

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

Housing starts are now running at the lowest level in nine months and building permits have declined for three straight months. Since the housing market is such a key driver to domestic economic growth, this latest reading on housing might give the Fed reason to pause on a September rate hike. Home prices and higher mortgage rates are far outpacing wage increases and the July data will be ever more telling.

With consumer price inflation near 2.4%, I do not see Personal Consumption Expenditures inflation, the Fed’s preferred gauge, sailing far above 2%, but the risk of investor anxiety rising on inflation is there after years of deflation fears. However, the pickup in U.S. inflation is not high or sticky enough to reverse monetary easing in the eurozone and Japan, which will keep downward pressure on long-term rates.

The other factor that investors have to consider is seasonality. The months of August and September are notoriously unpredictable for equity markets. While a spike in volatility might not repeat the scale of what took place in February, there is the possibility of China announcing other non-tariff-related measures to retaliate against U.S. tariffs, like slapping regulatory red tape on American companies doing business in China, or restricting further American business investment in China. A widening of the U.S.-China trade struggle outside of tariffs brings new uncertainty to the markets, and that could invite more volatility.

So, while I expect the current low-volatility landscape to persist over time, I see potential for episodic spikes amid confusion and uncertainty, as opposed to fundamental risks of economic growth slowing. In sum, stock selection will be at more of a premium during the August-September timeframe, while the market sorts out China’s economy, the Fed, European credit, oil prices, and currency manipulation.

While confidence is high and the Nasdaq and Russell 2000 trade at new highs and lead the current rally, that doesn’t mean the historical pattern won’t re-emerge. Over time, August and September have been the worst two months for equity market returns. The “Stock Trader’s Almanac” reports that, on average, September is the month when the stock market’s three leading indexes usually perform the poorest, so it’s a good time to consider selling stocks that have underperformed in what has been a bullish investing landscape of late. Trimming the fat from one’s portfolio is usually a good idea.

About The Author

Bryan Perry

Bryan Perry

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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