Tariffs Push Stocks Lower

The stock market sold off sharply on Wednesday because of President Trump’s proposal of a 10% tariff on $200 billion worth of Chinese exports. It’s important to recognize that this equates to a $20 billion tariff, not $200 billion. Sometimes articles falsely claim the tariff is the amount of goods being taxed. You can tell the tariffs caused stocks to decline because the Dow fell 0.88% after it had outperformed the Russell 2000 on Monday and Tuesday. The S&P 500 and the Russell 200 both fell 0.71%. You can also tell it was a selloff based on tariffs because the industrials fell 1.62%. Every sector was down except utilities as energy was the worst, falling 2.15%, and utilities were the best as they increased 0.87%.

This was also a selloff because the market was overbought. That overbought characterization didn’t show up on the 14 day RSI, but if you looked at shorter duration indicators, it was overbought. After this selloff, the CNN Fear and Greed index was at 40 which signals fear. If it wasn’t for the tariff announcement, we’d be talking about the record high being broken by the end of the month since earnings have been great.

It seems as if a tariff on all $500 billion worth of Chinese goods exported to America is an inevitable announcement unless China finally gives in to President Trump’s demands which include respecting intellectual property and lowering the trade deficit with America. The day that tariff is announced there will probably be one of the sharpest tariff related declines thus far. The good news is that announcement probably won’t come until after the review for this latest tariff starts on August 20th. The bad news is another negative catalyst could be coming because China will respond to these new tariffs shortly. The Shanghai index was down 1.76%. I think it’s good to see it decline because it means China is closer to giving in to America’s demands.

Treasury Yield Flattens Further

The 4 charts below show the curve is coming closer to an inversion almost every day. The 10 year minus the 2 year is at 27 basis points. The 10 year minus the 30 year is the closest to an inversion as it is only at 9.6 basis points. I wasn’t following the markets when the curve inverted in 2007, so I can’t attest to how sentiment was regarding the yield curve. Now, it seems like it is the most highly regarded indicator. This causes uncertainty because the more heavily relied upon an indicator is, the higher chance it will either be manipulated or cease to have meaning. On the other hand, because it is followed so closely by every investor I know, it could mean stocks sell off in anticipation of an inversion which occurs on average 21 months before recessions.

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Some investors will front run the indicator by selling immediately after the inversion. Some even took it a step further by selling now. There will be a massive rally if this indicator proves to be faulty. Since the economy is doing so well, this is one of the only indicators which is advising caution. The CAPE ratio explains why long-term returns will be bad, but since it’s not a timing indicator, it’s not going to be used as a justification to sell in the short term. It’s more of an indicator to look at when calculating expected returns and deciding what percentage of your portfolio should be in stocks. It’s a “don’t buy” signal rather than a “sell” signal.

The one way CAPE can be a short-term signal is if you look at the year over year ratio. If it is high and falling year over year, that’s a very bad sign. That warning sign hasn’t flashed yet as the current CAPE is 32.26 and the July 1st, 2017 CAPE was 30.00. The CAPE will fall when the 2019 earnings replace the 2009 earnings, but that’s not a sell signal because the point is to look at equity momentum, not improvements in earnings. It’s illogical to use earnings growth as a sell signal.

I don’t discuss global economies’ yield curves nearly enough. As you can see in the chart below, many major markets, particularly emerging ones, have seen their yield curve flatten. You can either say the American bond market is being manipulated by other markets because global central banks are more dovish than the Fed or you can say the yield curve is a more powerful signal because there is synchronized flattening.

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China Slowing Quickly

Following the Chinese economy is always important because it is so large, but it’s especially important since it can end the trade war. President Trump isn’t seeing political flack in the poll numbers from this trade war and the American economy is growing quickly. As a result of the latest PPI report and wholesale inventories report, the Atlanta Fed GDP Nowcast expects 3.9% Q2 growth. The CNBC rapid update, which averages 11 models, expects 3.9% GDP growth as of July 11th. It seems unlikely that Trump will be the one who loses this game of chicken.

As you can see in the chart below, the Chinese Citigroup economic data change index is declining the quickest. The indicators showing the BRICs and emerging markets are being pushed down by China. It’s not fair to say that they are falling a bit less than China; they are falling a lot less than China. I wish the chart included a line for emerging markets without China. Clearly, America is the best of the bunch in this chart as its index is above 100. One example of the weak Chinese data is its 8.5% retail sales growth in May. That missed expectations dramatically as the consensus expected 9.6% growth. China is not in a good position to deal with weakness in U.S. demand because of Trump’s tariffs. The country will continue to be pushed towards giving in to Trump’s demand to respect American intellectual property.

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