Two steps forward, one step back.

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HIGHLIGHTS:

  • Stocks retreat on setback in China trade negotiations.

  • Higher gas prices lifted consumer prices in April, but core inflation remains tame.

  • U.S. / China trade negotiations hit a snag, but optimism for a deal remains high.

  • Week Ahead: Focus on trade and economic reports as earnings season winds down.

Stocks retreat on setback in China trade negotiations.

Stocks fell for most of the week on a steady stream of news that the long-anticipated U.S. / China trade deal might stall, but then rallied on Friday after the trade meetings with senior Chinese officials ended with no agreement.  Federal Reserve interest rate policy and China trade have been the top two items on Via Nova’s Worry Checklist for 2019, and progress on both in the early months of the year helped lift the S&P 500 to record highs in recent weeks.  The sharp rally on Friday did not erase the losses for the week, but it did suggest that most investors believe a trade deal this year remains the most likely outcome.  We also believe a trade agreement is in the best interest of both sides and remains the most probable scenario, but the latest developments may be a sign that the trade and tariff frictions between the U.S. and China could continue longer than many expect and remain a cloud over the market.  Our concerns would grow if trade tensions with the EU and/or Japan intensify, as the combination of a China – EU – Japan trade conflict might precipitate a global recession.  The markets could remain vulnerable to each tweet and rumor.

The S&P 500 fell just over 2% for the week led by declines in technology, industrials and materials-three sectors closely linked to global trade.  Small cap stocks underperformed as did international equities.  Not surprisingly, emerging market stocks struggled most, losing over -4½% on word the trade talks were stalled.  Emerging markets have been the most vulnerable to trade frictions during the past year and have fallen -8% in contrast to the 8% rise in the S&P 500 during that time.

Bonds benefited from the uncertainty and the investor shift away from higher performing, but more volatile stocks.  The trade impasse raises the odds that the Federal Reserve may decide to lower short term rates, but Fed officials have yet to suggest rate cuts as a possibility.  The yield on the 10-year Treasury note slipped to 2.46%, which allowed further declines in home mortgage rates and lifted the Merrill Lynch Broad Bond Market Index by 0.3%. 

Other markets were mixed.  Real Estate Investment Trusts (REITS) declined while Treasury Inflation-Protected Securities (TIPS) rose.  Oil prices slipped, but gold prices firmed.  The value of the dollar was slightly lower.

Higher gas prices lifted consumer prices in April, but core inflation remains tame.

The latest round of economic reports showed a healthy labor market and continued tame inflation, which is good for consumers and suggests little need for additional rate hikes from the Federal Reserve.  The Job Openings and Labor Turnover (JOLTS) report showed more available jobs than available workers, suggesting a continued tight labor market, which is good for consumers, but a challenge for firms trying to hire.

Inflation pressures remained subdued in April according the Consumer Price Index (CPI) report.  The CPI rose a lower than expected 0.3% despite a nearly 6% increase in gasoline prices.  Core inflation, which excludes food and energy, inched up on 0.1% in April.  Both measures hovered near 2% over the past year, which is at the Federal Reserve’s target.

U.S. China trade negotiations hit a snag, but optimism for a deal remains high.

The U.S. and China were unable to strike a compromise in latest round of talks held in Washington.  Expectations were high that a deal was likely.  The impasse prompted the U.S. to raise tariffs to 25% from 15% on $200 billion in goods leaving China effective Friday.  President Trump also ordered staff to begin the paperwork to impose levies on the more than $300 billion worth of everything else China sells to the U.S.  China did not immediately retaliate with counter tariffs, though they have in the past.

The market rally on Friday suggests that optimism for a trade deal remains high.  While we agree, the risks of a protracted stalemate may have increased.  China does not want to appear to “back down” from the U.S., nor do they want to agree to provisions that would run counter to their longer run economic strategies.  If the trade negotiations become more philosophical and take on a nationalistic tone, an agreement will become more difficult.  In the meantime, U.S. companies are shifting production and supply lines away from China to other countries such as Viet Nam, Cambodia and India.  The shift is good for these emerging economies but is a negative for China, especially if the trade dispute is protracted and the shift becomes permanent.  However, the shift from one country to another does little to improve the U.S. trade deficit.

Week Ahead: Focus on trade and economic reports as earnings season winds down.

Trade news will be the primary focus for the markets in the coming week, as first quarter earnings season winds down.  China is likely to take some action in response to the increased U.S. tariffs, but the lack of an immediate response will keep the markets guessing.  Presidents Trump and Xi are scheduled to meet the end of June at the G20 Summit, but something is likely to happen before then.

The economic calendar is full, with updates on housing and manufacturing.  Both areas are expected to show improvement, particularly housing starts, which benefited from the recent drop in mortgage rates.