Submitted by Nick Colas of DataTrek Research
Markets continue to ignore rising trade tensions, essentially hanging their hat on a “Trump Tariff Put”. If stocks begin to worry that the President’s policies truly endanger economic and corporate profit growth and sell off, the administration will recalibrate. That works well now; we aren’t so sure it will hold next year. Bottom line: stay long US stocks with an eye to seeing this issue resolved before earnings growth slows next year.
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Since the middle of June we have argued that US equities have an imbedded “Trump Tariff Put” and posited this was one important reason to stay long domestic stocks. The idea here: President Trump measures his administration’s success in part by how the S&P 500 and Dow perform. If market fears of a real and lasting trade war were to sharply hit US stocks, he would moderate his position quickly. In principle our idea is similar to the “Fed put” – the notion that the US central bank eases policy whenever American stock markets swoon.
Aside from June 25th, when Peter Navarro had to walk back some chatter about restrictions on Chinese investment to help lift a sagging US equity market, this “Put” has remained part of the market’s scenery instead of in the spotlight. And today’s rally, which takes us to 10 S&P points shy of a new all-time high, came in the face of fresh tariff announcements from the White House. It seems the Trump Tariff Put is alive and well and investors view the Washington-Beijing drama as pantomime rather than Greek tragedy.
The important question now: how much longer will this dynamic last? We’ve seen inklings that trade/tariff uncertainty is beginning to weigh on corporate confidence, a worrying sign. Jessica noted in her Beige Book review last week that mentions of the topic are climbing quickly – and not in a good way. Given the tit-for-tat tariffs announced by China today, that trend towards greater concern will certainly continue.
Three points to consider:
#1. Trade war concerns are not the primary driver of US stock prices just now - corporate earnings are, and the momentum there continues to lift asset prices. Third quarter earnings growth should top 20% and Q4 will come close to that figure as well. Valuations are reasonable (given still low interest rates) at 16.8x forward 12-month earnings expectations.
When the Put starts to come into play: once we anniversary tax-cut fueled earnings growth in Q1 2019, earnings growth declines dramatically throughout the year. Right now analysts have 10% growth penciled into their models. That’s a much smaller buffer against the uncertainty created by trade frictions. Cut 2019 revenue growth from the expected 5% to 1-2%, and earnings growth goes to zero in an inflationary environment.
Bottom line: trade tensions, should they last in to 2019, will start to have a more pronounced effect on US equity volatility. Essentially, President Trump has until then to push hard for new agreements. Past that, markets will be much less forgiving.
#2. Fed policy doesn’t yet have to factor in the uncertainty around trade; that will also change in 2019. Fed Funds Futures give 82% odds that the central bank will raise rates twice more this year, essentially a lock. Fast-forward a year to the September 2019 contracts, however, and the future is much less clear. There could be one more bump (33% odds), 2 more (33% as well), or 3/+3 more (20%).
The upshot here is that Fed policymaking will be notably harder to predict in 2019 since there is no playbook for what to expect from a prolonged trade war. Add that to the prior point and you have the makings for more equity market volatility and a much lower strike price on the Trump Trade Put.
#3. As anyone who has made their living as a trader knows, markets have a strange way of pushing prices right to your pain threshold. So far, President Trump has only seen a bull market during his White House stay. The Tariff Put has been a background issue for him and never really gotten to a point where he had to reconsider his position.
Hidden from view but still present: the notion that any non-trade related exogenous economic shock would also force a reset on the tariff issue within the current administration. This could come in many forms, from oil price spike to unexpected geopolitical/financial event. Anything that hit US equity prices by 10% or more and increasing the chance of a recession would be reason enough to soften trade tensions. Slim comfort, this, but we’re overdue for such an event so it is worth considering.
Summing up: markets assume trade tensions will ease before we go off the earnings growth cliff in 2019. We think they are correct and maintain our positive view on US stocks. The fuse, however, is clearly burning