The S&P500 marked time for the week ending July 20, perhaps a more normal experience amid a season where the calendar cannot be counted as a friend to investors. The fact that the markets are behaved however might be surprising when considering what seems to be a continued escalation of trade tension between the Trump administration and the rest of the world. Arguably, the exchange of words and proposed trade adjustments are difficult to dismiss as only threats; at this point it would seem more accurate to suggest an actual trade war is already in progress; a development that would be expected to slow long-term global economic progress all other things equal while at the same time raising prices (definition of stagflation). Still, diving beneath the surface of what the S&P500 might tell us, Dow theorists – who view to the transportation sector as a indicative signal for the broader economic pace – might find some consolation with the notable outperformance of the transportation based constituents when compared to the relative performance of the industrials last week (both groups outperformed the S&P as a whole last week). This offers a contrast with what was being observed in the recent 4-week period and even YTD to a lesser pronounced extent.
From an economic perspective, it remains hard to find much wrong with the US economy. Corporate earnings look on pace to again jump +20% or more over the year ago comparative; unemployment is still at all-time lows and workers are being rewarded for quitting to take other jobs (upgrading pay and/or better matching their skills with the work); consumers appear healthy and willing to spend; and inflation remains non-problematic. Internationally the picture is less supportive: political populism is again showing its head and making governing more challenging; hard economic data is stagnating; and a strengthening US dollar is making dollar-denominated debts more expensive to service. Tariffs would appear likely to harm those exporting the most to the US – the continues to effectively confirming that view with the dramatic underperformance of foreign markets relative to domestic. And while observing the relative performance of various global financial markets can be useful, it is also hard to fully predict how tariffs might fully impact various sectors and businesses, or begin to impute lasting damage to confidence. Only time will fully reveal how businesses adapt and navigate changing trade rules and/or evolution into also being a currency war.
Closing the loop, US equity performance is encouraging considering the numerous bricks available to stack on the “wall of worry”. Economic fundamentals are supportive; but tariffs are not. Inflation appears healthy after years where deflation was the more acute concern; yet the Federal Reserve appears too committed to a path of additional hikes. It is noteworthy too that President Trump broke with years of historical precedent when speaking both publicly and separately on Twitter last week pointing criticism at the Fed and communicated preference to continue raising rates. It may be that his comments are as much intended to mitigate Chinese currency devaluation as much as anything. But the criticism is not without significant merit: inflation still appears within the acceptable range and the US dollar has already experienced significant appreciation in 2018 (making US goods more expensive to foreign buyers). One Trump tweet also reminded of the very alarming point that financing deficit spending becomes exponentially more expensive if key interest rates are higher. Need stronger evidence? The yield curve is meaningfully flattened YTD and looks on pace to invert (an ominous leading recession indicator) sometime in early 2019 if not altered confirms that the Fed is going too fast. Yield curves should never invert (meaning borrowing in the short-term is more expensive than long-term) and indicate a policy mistake has occurred. All that aside, the Fed is designed to be an independent body from that of fiscal policy. Many would argue that such high profile critique actually increases the odds the Fed maintains its present course so as to avoid any perception that it takes cues from the Executive branch. The third week of July was one in which domestic markets were unable to build on what is so far a great start to the 3rd quarter. Considering all the unsettling developments, we’ll take that result when combined with undeniably strong corporate earnings growth any day!