Given the tremendous amount of political activity surrounding financial markets so far this year, it might be hard to believe that the S&P 500® Index is higher by 2.81% rather than down by a double-digit percentage. While stocks are lower from their recent higher levels, as of yesterday’s close, the S&P 500® Index is still higher by 5.21% since our last missive written on March 24th.
So, despite all the hand-wringing over a potential trade war, immigration-related headlines, elevated tensions related to North Korea and a Federal Reserve that has raised interest rates for the second time this year, stocks have remained steady.
Here at KIG we have been keeping a close eye on all the major news affecting markets. Despite the modest move in stocks since the beginning of the year, volatility has been high throughout. This increase in volatility is something we warned clients to prepare for and this warning has proven to be warranted. We expect volatility to increase in the third quarter.
Since the beginning of the year, there has been a tug of war of sorts between the effect of negative political headlines (immigration, tariffs, Korea, rising interest rates) and positive economic news (corporate tax cut, record corporate profits). So far, the “tug of war” has resulted in only a meager 2%+ gain for stocks this year. We expect a stronger move is coming for stocks. The question is, in which direction?
We will never lose sight of the risks that exist which could push stocks much lower from here. However, our view is that stocks are going to end the year noticeably higher than where they began the year. Our view is based on an expectation that trade negotiations will turn more conciliatory over the next several weeks.
As a reminder, we distill away any personal political bias to prevent it from affecting investment decisions here at KIG. Our duty to clients is to navigate markets without regard for ideology. Given the politically-charged environment in which we live, we feel compelled to emphasize this point.
Before we spell out reasons for our optimism for stocks over the rest of the year, here are the negatives which are on our radar.
First, the Federal Reserve is on track to raise interest rates two more times this year. If the economy begins to stall and send long-term interest rates lower, the yield curve might invert which could signal a recession. An inverted yield curve is one in which short-term rates (2-year Treasury Bills) yield more than long-term rates (10-year Treasury Note). Historically, this event has preceded a recession with a high degree of accuracy.
Second, a full-fledged trade war could erupt. While it may seem as though the war has started, it has not. Trade wars are not good for the economy and, like real wars, take a while from which to heal. In fact, a trade war is exactly what could lead to a slowing economy which, in turn, could lead us to the recession referenced above.
These are couple of the risks which stand out but there are always those which seemingly come out of nowhere. For these, we simply remain vigilant and nimble to avoid.
As for reasons we are constructive, there are several. Ultimately, we believe trade tensions will subside and the strength of corporate profits will act as a catalyst for higher stock prices.
We think trade tensions will abate over the next 6-8 weeks. Our sense is that trade negotiations are going according to President Trump’s game plan. That is, real pain must be felt before it can be inflicted. In other words, for any negotiation to be effective, both parties must prove their willingness to sacrifice. Car salespeople rarely bring their best offer to the buyer until the buyer is willing to show they can do without the car.
In preparation for the “pain” involved in negotiating new trade deals, President Trump pushed for substantial corporate tax cuts. The sequence of events (corporate tax cuts followed by full-fledged re-negotiating of trade deals) has been deliberate. Knowing that tariffs would be damaging to U.S.-based companies, it was important to provide tax relief ahead of them being implemented.
It is also well-known that President Trump uses stock market performance as a gauge of how well his policies are being received. While stocks have sagged lower since the tariff talk began, they have not collapsed in any way. Sometimes stocks holding steady or only dipping slightly is a positive surprise compared to where they could go. Our observation here is that while stocks have dropped from their peak in January, they are still positive for the year. In the face of all the negative trade-war talk, this is quite impressive performance for stocks. This might just be seen by the president as a positive response, too.
To this end, we do not expect the president to push the tariff war so far that it does irreparable damage to the stock market or the economy. But, we do expect him to take it until he sees the “whites of their eyes.” Risky business to be sure, but if one wants to re-negotiate long-standing agreements, some pain must be endured.
The risk of the president taking the country into a full-fledged trade war would be higher, we believe, if he was an ideologue. We believe he is a deal-maker and not an ideologue. His penchant for profits prevents him from putting political philosophy ahead of profits. We withhold opinion on whether this is “good” or “bad” for the country. Rather, we look at it as a window into the president’s negotiating tactics.
As a former infantry officer, I was required to read the book “The Art of War” by Sun Tzu. The wisdom found in this tome is essential for anyone engaged in “war.” Our president wrote a book, too. It is called “Trump: The Art of the Deal”. We think President Trump is far more likely to seek out a “deal” than a “war.”
We anticipate the direction of the next 10% move in the broad market will be revealed within 6 weeks or so. If we see the S&P 500® Index dip below 2,695 on heavy volume, the direction very well could be “down.” If we see the Index hold above this level AND a tariff deal is struck, we think stocks will move higher into the end of the year.
If the move is to the downside, we still believe it will be a garden-variety correction and not the beginning of a bear market. We remain very positive over the long-term and believe any such decline should be “bought” by investors and not feared by them.
Happy 4th of July!
Kessler Investment Group, LLC