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S&P 500 drops 3.1% as trade war with China escalates

Owning the stock market over the long term is a winner’s game, but attempting to beat the market is a loser’s game. – John Bogle

After closing at record highs the previous week, fortunes turned for both the S&P 500 Index and the Nasdaq Composite Index last week as both benchmarks suffered their worst performance of the year with losses in excess of 3%.  The tipping point for the market seemed to begin on Wednesday when the Federal Open Market Committee (FOMC) cut the federal funds rate by 25 basis points to a range of between 2.00% and 2.25%, a move that was widely expected. But investors were disappointed with comments made by Federal Reserve Chairman Jerome Powell, who said that the rate reduction was a “mid-cycle adjustment” and not the start of a trend. Although the Fed cited “global developments” along with “muted inflation” as reasons for easing monetary policy, investors concluded that future interest rate cuts were not a sure thing. Stocks sold off on the news and the major stock averages closed about 1% lower on the day. Weaker than expected manufacturing data on Thursday was actually welcome news for investors and stocks rebounded as they bet that the Fed would likely cut rates again. After erasing all of the losses from Wednesday, stocks plunged again when President Trump tweeted that the U.S. would impose an additional 10% in tariffs beginning September 1st on a total of $300 billion of Chinese goods that had been excluded from previous tariffs. The timing of the announcement surprised investors as U.S. and Chinese trade officials were meeting in Shanghai to try to reach a trade agreement after a truce was declared just last month. Not only were stocks weak, but the yield on the 10-year Treasury plummeted to 1.86% and the 2-year Treasury yield fell to 1.72%. (Bond yields move inversely to prices).The price of oil also dropped nearly 8% as fears of a global economic slowdown gripped the markets. For the most part, second quarter corporate earnings continued to be better than expected last week and economic reports in the form of jobs data were also in line with estimates. But this positive news took a back seat to the escalating trade war and its implications for the global economy.

Last Week

The July employment report showed that 164,000 new jobs were created, slightly less than forecast, and that the unemployment rate remained unchanged at 3.7%. Wage growth was slightly better than expected. Consumer confidence in July recorded its highest level this year as consumers are optimistic about business prospects and the outlook for the labor market. The Purchasing Manager’s Index (PMI) for manufacturing in July slipped to 51.2, its lowest reading since August 2016, but still remained in expansion territory. June factory orders also rose modestly and were in line with estimates.

Apple beat revenue and earnings estimates in the second quarter and issued an upbeat forecast for the current quarter. More than half of S&P 500 companies have reported earnings and about three fourths of them have exceeded expectations.

For the week, the Dow Jones Industrial Average lost 2.6% to close at 26,485 and the S&P 500 Index dropped 3.1% to close at 2,932. The Nasdaq Composite Index declined 3.9% to close at 8,004.

This Week

It will be a quiet week for economic data, especially compared to last week. The producer price index (PPI) for July is expected to edge slightly higher and show a year-over-year increase of only 1.6%. The ISM non-manufacturing or services index for July is forecast to be slightly higher than in June and comfortably in expansion territory.

Among the most notable companies on the earnings agenda this week are Marriott, Walt Disney, CBS, Viacom, Tyson Foods, Duke Energy, Devon Energy, Marathon Oil, Emerson Electric, American International Group, CVS Health, Becton Dickinson and Cardinal Health.

Portfolio Strategy

The announcement by President Trump that imposed additional tariffs on Chinese imports had a bigger impact on the bond market than the stock market. The yield on the 10-year Treasury fell from 2.07% at the start of the week to just 1.86% on Friday, a drop of 21 basis points (A basis point is one hundredth of one percent). This was the lowest yield on the 10-year Treasury since November 2016. Short-term Treasury yields also fell as the 2-year Treasury yield ended the week at 1.72%. Not only was there a decline in yields across the yield curve, but the difference between the 10-year Treasury and the 2-year Treasury compressed to only 14 basis points, a worrisome sign that the global economy is slowing. Reaction in the bond market was even more pronounced with Trump’s tariff announcement than with the Federal Reserve’s rate reduction. The effect of additional tariffs could be a further slowdown in economic growth with a much greater likelihood of another cut in the federal funds rate in September. The latest round of tariffs will definitely affect consumer goods and might have a more adverse effect on the economy. Consumer spending accounts for nearly 70% of economic activity. Investors should be careful what they wish for as markets are becoming more dependent on dovish central banks and lower interest rates. The uncertainty created over these new tariffs and the likely negative effect they will have on the economy could be problematic for stocks unless a trade agreement can be reached soon.