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Stocks close lower as China retaliates in ongoing trade war

There’s never been a market timer on the Forbes richest people in the world list. If it were truly possible to predict corrections, you’d think somebody would have made billions by doing it. – Peter Lynch

The stock market experienced its worst day since early January last Monday and wound up closing modestly lower for the week. After the U.S. announced that it would raise tariffs from 10% to 25% on $200 billion worth of Chinese goods the previous week, China retaliated on Monday as expected by hiking tariffs to 25% on $60 billion of U.S. imports starting on June 1st. The escalation of the trade war by both sides caused the S&P 500 Index to plunge nearly 2.5% on the first trading day but it managed to recoup most of those losses by week’s end. The Trump administration also made it more difficult for U.S. companies to do business with Huawei, the giant Chinese telecommunications company, by requiring them to have a license. To make matters worse, consideration has been given to imposing tariffs on another $300 billion of Chinese goods. While the two countries maintain that they are still in negotiations, it appears that talks have stalled and a realization is setting in that a trade deal may be a long way off. Neither country stands to win from a long and protracted trade war and the uncertainty will undoubtedly lead to further volatility in the markets until an agreement is finally reached. Fortunately, the fundamentals of the economy remain strong. First quarter earnings have been excellent and that was evident last week as Wal Mart and Cisco Systems reported better than expected earnings and both companies issued stronger than forecast revenue guidance. For the most part, economic data has also been mostly positive as the current expansion will enter its eleventh year in July, becoming the longest in history. But a prolonged trade war with high tariffs will negatively impact growth and result in higher inflation, reduced capital expenditures, increased policy uncertainty, slower job growth and weaker productivity growth. The sooner a trade agreement is reached, the better it will be for both sides.

Last Week

It was a mixed bag for economic data last week. On the positive side, import prices rose only slightly in April, helped by a decrease in the price of capital goods that suggests inflation should remain under control for a while. Housing starts were better than expected in April and the home-builder confidence index hit a 7-month high in May. Weekly jobless claims fell by 16,000 to 212,000, which was lower than expected and near the lowest level in 50 years. April leading economic indicators also recorded their third straight monthly gain and indicated that growth should continue, albeit at a modest pace. On the negative side, retail sales fell slightly in April after posting a big increase in March and industrial production also fell more than expected in April.

Increased trade tensions also took their toll on China as Chinese industrial production and retail sales were disappointing in April and less than expected.

For the week, the Dow Jones Industrial Average dropped 0.7% to close at 25,764 and the S&P 500 Index  fell 0.8% to close at 2,859. The Nasdaq Composite Index declined 1.3% to close at 7,816.

This Week

Both April new home sales and existing home sales are expected to be in line with the numbers reported in March while April durable goods orders are expected to decline slightly after posting a big increase in March. The Federal Open Market Committee (FOMC) releases minutes from its monetary policy meeting earlier this month.

Retailers will dominate this week’s earnings reports as TJX Companies, Home Depot, Nordstrom, Williams-Sonoma, Kohl’s, JC Penney, Best Buy, Target and Lowe’s are scheduled to report. Other companies on the agenda include Analog Devices, Autodesk, HP and Medtronic.

Portfolio Strategy

While trade tensions have certainly had a negative effect on the stock market, their effect on the bond market has been far greater. After tumbling almost 2.5% on Monday, the S&P 500 Index staged a rebound and only closed modestly lower for the week. The bond market, on the other hand, has rallied on the belief that the trade war with China will slow the U.S. economy enough to cause the Federal Reserve to lower interest rates to avert a recession. Equity investors remain somewhat optimistic that a trade deal will eventually be reached as stocks remain near their historic highs despite recent losses. The fixed income market, though, is focused on the likely slowdown in the economy after gross domestic product (GDP) was a robust 3.2% in the first quarter. Yields on Treasuries have fallen to the lowest levels in more than a year. (Bond yields move inversely to prices). The 2-year Treasury yield is only 2.20% while the yield on the 10-year Treasury is just 2.39%. The odds of an interest rate cut by the Federal Reserve have also increased, although most economists believe that the Fed will stand pat for the balance of the year and even into 2020. Yields have fallen across the yield curve but the spread or difference between the 2-year Treasury yield and the 10-year Treasury yield has actually widened a little bit. The lower yields may portend slower economic growth in the months ahead, but the fact that the yield curve is still positive and upward-sloping suggests that there is no recession on the horizon.