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Pullback!
The S&P 500 has dropped 5% in the span of four trading days, thanks to three specific events:
- First, the Fed disappointed markets by only cutting rates 25 basis points and not signaling that more rate cuts were on the way.
- Second, on Thursday President Trump threatened to impose a 10% tariff on $300 billion of Chinese imports on September 1st, which escalated the U.S./China trade war.
- Finally, this morning, Chinese authorities let the yuan weaken to an 11-year low vs. the dollar.
That last event, while the most obscure, is actually the most important, because it signals the Chinese are preparing for a long U.S./China trade war, and that hopes for a deal in 2019 are now very slim.
The weakening of the currency below 7/dollar by the Chinese authorities will provide some short-term economic benefit; but also has broader risks. It's not a move to be taken lightly, and it signals one of two things:
Most likely, it's that the Chinese are preparing for a long, drawn-out trade war with the U.S. Practically, the yuan weakening materially reduces the chances of a U.S./China trade deal in the near term--something stocks have priced in. From a global growth standpoint, it means the global economy will likely face additional headwinds and the chance of a global slowdown is higher now than it was Friday--and that's why stocks are down.
The other reason for the yuan weakening is that Chinese authorities are very worried about economic growth. That's not the more likely reason for this move, but either way, it's still negative if true.
Bottom line, this adds more uncertainty to the macro outlook and is further pressuring the market multiple, and stocks are reacting accordingly.
This is particularly concerning because the last time we had Chinese currency worries was back in August 2015 (almost exactly four years ago), and that currency volatility caused a near 11% pullback in the S&P 500. Last week, we cautioned that this market was vulnerable to a pullback should the Fed fail to meet very dovish expectations or if we got any more negative surprises as stocks were largely "priced to perfection."
The S&P 500 is now near a key support level (S&P 500 EPS 178 x 16 multiple = 2,848). So we're at a bit of a fork in the road for this market. Very dovish central bank expectations combined with a new trade truce and hints of stability in economic data propelled stocks 10% higher between late May and late July. Clearly that bullish assumption was premature, and what will decide the next 200 points in the S&P 500 is how each of these issues resolve themselves.
Positively, it's still somewhat reasonable to think the 10% tariffs won't actually go into effect on Sept. 1, and they are just a negotiating tactic. Additionally, this Fed has shown a propensity to try and fix its communication mistakes quickly; so there's a decent chance the Fed is more dovish at the September meeting. Finally, economic growth showed stability in July, and if we see a continued uptick in global growth, that'll be a positive for stocks. That's the bullish scenario, and it would result in the S&P 500 revisiting 3000 and likely rallying to new highs.
Negatively, it's also quite reasonable to think the 10% tariffs do go into effect, and we have to live with escalated trade tensions through November 2020 (the U.S. election). That will be a real headwind on business spending and investment and global economic activity. Additionally, the Fed may stick to its guns. They clearly don't want to placate the market with "shock and awe" monetary policy; so if they get materially more dovish it's probably going to be because they think they have to (which isn't good for stocks in the long run). Finally, and this is important, if U.S. economic data begins to roll over; that's a serious negative for risk assets and would be a "bearish game-changer" in our minds--simply because it'll signal the end of the decade long expansion.
Source: Roda Investment Management
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