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Trade war fears rattle the stock market, Dow falls 2%

It’s not always easy to do what’s not popular but that’s where you make your money. Buy stocks that look bad to less careful investors and hang on until their real value is recognized. – John Neff, former fund manager of the Vanguard Windsor Fund

The Dow Jones Industrial Average snapped its 8-day losing streak on Friday and wound up losing 2% for the week as trade tensions between China and the U.S. continued to linger. The S&P 500 Index and the Nasdaq Composite Index also retreated although the losses were modest by comparison. The Russell 2000 Index of small cap stocks bucked the trend and ended the week flat. This index has risen nearly 10% this year as investors have realized that small companies primarily transact business in the U.S. and are unaffected by tariffs and trade practices. Initially, the U.S. announced tariffs on $50 billion worth of Chinese goods, which prompted China to respond by slapping $50 billion in tariffs on U.S. products. Last week, however, President Trump ratcheted up the rhetoric by threatening to impose a 10% tariff on an additional $200 billion worth of Chinese goods if China doesn’t stop its unfair trade practices. As expected, China vowed to retaliate against the U.S. and said that the U.S. “had started a trade war that violates market laws.” Trump even threatened to place a 20% tariff on European automobile imports. The real possibility of more tariffs could impact GDP growth, adversely affect consumer and business confidence and increase prices and lead to higher inflation. None of these outcomes would be beneficial for the stock market and, as a result, companies like Boeing, Caterpillar and other industrial stocks suffered the brunt of the selling as they have large amounts of overseas business. To add to the uncertainty, Federal Reserve Chair Jerome Powell reiterated last week that the Fed plans to gradually hike interest rates to normalize monetary policy. He cited a tight labor market, solid economic growth and inflation at its target as reasons for two additional rate increases this year. With the likelihood of higher interest rates later this year combined with the negative effects of a looming trade war, it’s not surprising that investors took some profits last week.

Last Week

It was a relatively quiet week for economic data as the leading economic indicators for May rose modestly for their seventh straight monthly gain, although it was less than expected. U.S. existing home sales declined in May for the second consecutive month as a shortage of homes for sale caused home prices to rise faster than wages.

Walt Disney raised its bid for 21st Century Fox to $71.3 billion in cash and stock, topping Comcast’s bid of $65 billion. General Electric, which had been an original member of the Dow Jones Industrial Average since 1896, will be removed and replaced by Walgreens Boots Alliance on June 26th.

For the week, the Dow Jones Industrial Average dropped 2.0% to close at 24,580 while the S&P 500 Index fell 0.9% to close at 2,754. The Nasdaq Composite Index declined 0.7% to close at 7,692.

This Week

The final first quarter gross domestic product (GDP) number should remain at 2.3% while durable goods orders for May are forecast to record a slight drop. The June consumer confidence and Michigan sentiment indexes are expected to remain elevated and consistent with previous months, which bodes well for consumer spending. The June Chicago Purchasing Manager’s Index (PMI) is expected to top 60, a sign of strong expansion, and May new home sales are expected to be strong and slightly higher than last month.

The Federal Reserve will release the second part of its annual bank stress tests.

Among the most notable companies scheduled to report quarterly earnings this week are Nike, General Mills, McCormick, ConAgra Brands, Constellation Brands, Accenture and Walgreens Boots Alliance.

Portfolio Strategy

On an annual basis, the Federal Reserve reviews the capital adequacy of U.S. banks and U.S. subsidiaries of foreign banks to determine if they can withstand adverse economic and financial conditions, such as what occurred during the Great Recession and financial crisis in 2008. Last week all of the banks under review passed the first stress test, which measures their ability to weather a steep downturn in the economy. This week the second test will determine the amount of dividends that banks can pay as well as the amount of their own stock they can repurchase. Expectations are high that approval will be granted for banks to substantially increase their dividends and stock buybacks, both of which should provide a much needed boost to bank stocks, which have lagged the overall market this year. The S&P 500 Index has posted a year-to-date total return of 4.0% this year while bank stocks have remained virtually flat. In addition to lingering trade tensions and tariff concerns, banks have also been hurt by a flattening of the yield curve and slowing loan growth. For these reasons, bank stocks are relatively cheap and trade well-below the market multiple, making them attractive for value-oriented investors. No industry group is expected to return more capital to shareholders in the form of dividends and share buybacks over the next year than banks. This windfall could change the fortune of bank stocks going forward and provide an attractive total return for investors.