Stocks close lower on continued trade war fears

The intelligent investor is a realist who sells to optimists and buys from pessimists. – Benjamin Graham

The Dow Jones Industrial Average was poised to end the second quarter with a gain of nearly 300 points on Friday but the rally fizzled in the last hour of trading and the index managed a gain of only 55 points. For the week, all three of the major stock averages closed modestly lower as global trade tensions and trade war fears continued to roil the market. The Russell 2000 Index of small cap stocks, which is generally not affected by tariffs and, as a result, surged over 7% during the second quarter, also closed lower last week. Small companies sell most of their products in the U.S. and, for this reason, would not be hurt as much by a trade war. Uncertainty over trade seemed to overhang the market all week. On Monday, President Trump announced plans to prohibit several Chinese companies from making investments in U.S. technology. He also suggested that certain technology exports to China should be blocked and that Chinese investors should be prohibited from acquiring U.S. semiconductor companies. But the next day Treasury Secretary Steven Mnuchin denied a report that there were plans to limit Chinese investment in U.S. technology. Peter Navarro, a trade advisor to President Trump, also said there were no plans to place investment restrictions on China or any other country. Later in the week, President Trump decided that the Committee on Foreign Investment in the U.S. would handle any cases involving the foreign purchase of domestic technologies. While this decision was less onerous and less restrictive than feared, investors were still in the dark over the administration’s policy on tariffs and trade. The confusion and uncertainty over conflicting statements on trade and the lack of clarity on the government’s policy will likely continue to plague the stock market as business sentiment and economic growth could be adversely affected.

Last Week

The final reading for first quarter gross domestic product (GDP) was revised lower to 2.0% from 2.2% as consumer spending was the weakest it has been in nearly 5 years. New home sales in May were much better than expected but durable goods orders in May unexpectedly fell as demand for transportation equipment was weak. Both the June consumer confidence index and the University of Michigan consumer sentiment index fell slightly but remain at high levels as consumers’ attitudes toward their economic prospects were negatively impacted by tariffs. Weekly jobless claims rose by 9,000 to 227,000 but claims remain at historically low levels and very few people are being laid off.

For the week, the Dow Jones Industrial Average dropped 1.3% to close at 24,271 and the S&P 500 Index also fell 1.3% to close at 2,718. The Nasdaq Composite Index declined 2.4% to close at 7,510.

This Week

The June employment report will be released on Friday and expectations are for 190,000 new jobs to be created and for the unemployment rate to remain at 3.8%. Construction spending in May is expected to rise modestly while May factory orders are expected to edge slightly lower. The Federal Open Market Committee (FOMC) will release minutes from its June meeting, which saw members raise the federal funds rate by 25 basis points and forecast a total of four interest rate hikes this year.

The U.S. markets will close early on Tuesday July 3^rd and will be closed on Wednesday July 4^th in celebration of Independence Day.

There are only five companies that are scheduled to report quarterly earnings this week and none of them are considered prominent.

Portfolio Strategy

One worrisome sign last week was the decline in the 10-year Treasury yield to 2.85% and the corresponding flattening of the yield curve, the difference between short-term rates and long-term rates. As the Federal Reserve has raised the federal funds rate twice this year and has forecast two more rate hikes in 2018, the yield on the 2-year Treasury has risen to 2.52%. The yield on the 10-year Treasury had been as high as 3.1% as recently as mid-May but now is only 33 basis points (a basis point is one hundredth of a percent) higher than the 2-year Treasury yield. This spread between the two yields is as low as it has been in a long time and is indicative of a slower economy and milder inflation than most economists had predicted. Gross domestic product (GDP) in the first quarter was only 2% and the core consumer price index (CPI) increased by just 2.2% in the 12 months ended in May. While most economists have forecast GDP growth in excess of 4% in the second quarter, investors are looking at the second half of the year and are having doubts that this level of growth can be sustained. There are serious concerns that if a trade war breaks out with either China, Canada or Europe, then economic growth could be impacted. There also is a wide disparity between the 10-year Treasury yield and yields on comparable government securities overseas. For example, the difference between the yield on the 10-year Treasury and the comparable German government bond was recently about 2.5 percentage points. That discrepancy is a major reason that Treasury bond prices have risen and kept yields relatively low (Bond prices and yields move inversely to one another). With the rise in short-term rates and the decline in longer-term rates, there is no reason to extend maturities to pick up incremental yield. The yield on the 2-year Treasury is now nearly 90% of the yield on the 10-year Treasury. This relationship is important to watch since an inverted yield curve, in which short-term interest rates are higher than longer-term rates, can portend a recession.