Stocks overcome trade war fears to post solid gains

Forecasts may tell you a great deal about the forecaster; they tell you nothing about the future. – Warren Buffett

The stock market overcame persistent trade war fears last week to post solid gains as the second quarter earnings season began. The Dow Jones Industrial Average managed to climb back above the 25,000 level, the S&P 500 Index closed above 2,800 for the first time since February and the Nasdaq Composite Index finished at a record high. All of this good news came even though the Trump administration threatened to impose tariffs on an additional $200 billion worth of Chinese goods. While these proposed tariffs will be reviewed first and would not take effect until the end of August, the markets are sensitive to any tariff-related news lately and stocks plunged on the announcement. Both U.S. and China officials indicated that trade talks could resume, though, and that optimistic scenario helped stocks to recover. Investors also focused on the beginning of the second quarter earnings season and, by all estimates, it is expected to be an excellent one. After increasing 24% in the first quarter, corporate earnings are forecast to grow by about 20% in the second quarter as economic growth accelerated. Early results were encouraging last week as PepsiCo and Delta Airlines beat analysts’ estimates along with financial heavyweights JP Morgan Chase and Citigroup. As long as corporate earnings continue to be strong and guidance going forward remains favorable, trade war fears should take a back seat and stocks could add to their recent gains.

Last Week

Economic data last week centered primarily on inflation as the producer price index (PPI) in June was slightly higher than expected. The core PPI, which excludes food and energy, has increased 2.7% in the 12 months through June. The consumer price index (CPI) rose slightly in June and was less than expected and the core CPI has risen 2.3% in the 12 months ended in June. U.S. import prices in June were expected to increase slightly but fell nearly half of one percent. Overall, the monthly inflation data was relatively benign and even though inflation is now the highest it’s been in six years, it remains under control. The preliminary University of Michigan consumer sentiment index in July fell slightly due to rising concerns about the potential impact of tariffs on the economy.

The decision to approve the $81 billion merger between AT&T and Time Warner will be appealed by the Department of Justice and shares of AT&T closed lower for the week.

For the week, the Dow Jones Industrial Average surged 2.3% to close at 25,019 and the S&P 500 Index gained 1.5% to close at 2,801. The Nasdaq Composite Index added 1.8% to close at 7,825.

This Week

Retail sales in June are expected to increase for the fourth consecutive month as consumer spending remains strong. June housing starts are expected to be consistent with totals in May and indicative of a healthy housing market while June leading economic indicators are forecast to be twice the reading in May.

In overseas news, President Trump and Russian leader Vladimir Putin are scheduled to meet in Helsinki, Finland, China is expected to release second quarter GDP and retail sales data and the International Monetary Fund (IMF) will release its World Economic Outlook.

Financials will again dominate this week’s earnings reports as Bank of America, Blackrock, Morgan Stanley, Charles Schwab, Goldman Sachs and American Express are scheduled to report. Other notable companies on the agenda include Johnson & Johnson, Abbott Labs, UnitedHealth, IBM, Microsoft, Netflix, GE, Honeywell, Union Pacific and Philip Morris International.

Portfolio Strategy

In addition to the nagging uncertainty with regard to increased tariffs and trade war fears, investors also must worry about a more hawkish Federal Reserve and further interest rate hikes. The Fed seems intent on normalizing monetary policy even as inflation remains relatively subdued. The Fed’s preferred measure of inflation, the personal consumption expenditures (PCE) index, only just recently hit its target of 2%. But with expectations rising for higher inflation and stronger economic growth, one would expect longer-term interest rates to be increasing and not decreasing. As of Friday, the 10-year Treasury yield was 2.83% and the 2-year Treasury yield was 2.59%, a difference of only 24 basis points. The spread between the two has not been this narrow in a long time and raises fears that a flattening yield curve could eventually become inverted and lead to a recession. An inverted yield curve has preceded the past seven recessions and has been a reliable indicator of a bear market in stocks. This time may be different, though. The Fed has been raising interest rates gradually and no one is clamoring for more aggressive tightening to combat stronger inflation. Although economic growth is forecast to pick up significantly in the second quarter, it’s expected to level off and approximate 3% for the year. Perhaps the biggest reason for the flattening yield curve has been the continued negative-interest rate policies of the European Central Bank (ECB) and the Bank of Japan (BOJ). Their deposit rates remain slightly below zero and have caused 10-year government bond rates to drop to very low levels, making U.S. Treasuries much more attractive to investors, especially as the dollar has strengthened this year. While the flat yield curve is certainly worrisome, there are enough valid reasons to explain it and dismiss fears of an imminent recession, at least for now.