Markets Drop on Trade War Fears

Posted by Brad McMillan, CFA, CAIA, MAI

Find me on:

This entry was posted on Aug 6, 2019 2:02:18 PM

and tagged Commentary

Leave a comment

marketsThe past week has been a tough one for stock investors. The S&P peaked on July 26, and it has dropped every day since then for a total decline of almost 6 percent (as of the close of August 3). This is a large and fast drop that has understandably rattled investors, who wonder why the sudden pullback—and whether it will continue.

Trade war moves into hot zone

The drop was triggered by a renewal of the trade conflict between the U.S. and China. The U.S. ratcheted up the conflict by threatening to impose a new range of tariffs of 10 percent on $300 billion of imports from China. China retaliated by canceling orders of U.S. agricultural goods and allowing the exchange rate for its currency to drop below 7 against the U.S. dollar for the first time ever. The market had largely grown used to U.S. threats, but the Chinese retaliation is a new element that has threatened to take what had been a cold trade war into the hot zone. Such a hot trade war would meaningfully threaten corporate earnings by causing lower sales and higher costs around the world.

Given this, the cause of the pullback is clear: corporate earnings will be threatened, and as stock prices depend crucially on those earnings, prices have pulled back. With sales to China potentially down and with costs rising as companies relocate their supply chains to more expensive areas, a 6 percent drop in earnings is certainly possible. In that sense, the size of the pullback makes sense, as it reflects a reasonable estimate of the potential earnings damage. The speed of the pullback also makes sense, in that the causes—U.S. policy and Chinese reaction—took place over a period of days, just as the pullback did.

Looking at the recent pullback this way, we can see it not as some bolt out of the blue but as a rational reaction to changes in policy and the subsequent economic impact. With this understanding, we can also draw some conclusions about what likely comes next.

Markets reacting rationally

First, markets are indeed reacting rationally. There is a clear connection between what is happening in the news, what it means for corporate earnings, and what happens to stock prices. Markets are reacting as they should.

Second, we may see more volatility. As the U.S. and China duel back and forth on policy, the markets will keep responding to that new information. If earnings look likely to get hit, we could see more of a decline. On the flip side, markets are also likely to respond if policy looks to be less damaging. If, for instance, the U.S. and China cut a deal or even agree to keep talking, we could see a recovery. This recent drop is not necessarily the start of a larger decline but a response to circumstances—which could go either way.

The good news?

The good news is that a deal should be reachable. The U.S. made its point with the tariff announcement, while the Chinese have now made theirs with the agricultural order suspension and currency manipulation. These are likely both negotiating tactics, rather than a determination to start a trade war. We have seen this kind of back-and-forth before, although at a lower volume, and the result has been a deal. An agreement remains the most probable result this time, in which case we could see a recovery in both expectations and stock prices.

The real risk here is that if the confrontation continues, it will increasingly affect both business and consumer confidence. Business confidence has already pulled back, although it remains expansionary. But consumer confidence remains strong. The U.S. economy largely depends on internal demand. So, a pullback in consumer confidence is what could ultimately cause a deeper and longer decline in financial markets. This scenario, however, would take time. And unlike the stock reaction, it would not be immediate.

Not time to panic

We therefore need to pay attention to how the situation evolves, but now is not a time to panic. So far, we are seeing a rational reaction by markets to a change in circumstances; moreover, it is one we have seen before. Chances are that a deal will be reached and conditions will normalize.

Even if they do not, the fact is that the U.S. economy remains solid—and that will not change overnight. With hiring still strong, with consumers confident and spending, and with the recent rate cut by the Fed providing a tailwind, there is a considerable amount of cushion for financial markets to help them weather the policy-related turbulence around the trade war. Any decline will likely be gradual, and we will have time to respond.

Remain calm and carry on.

Subscribe via E-mail

New call-to-action
Crash-Test Investing
Commonwealth Independent Advisor

Hot Topics

Have a Question?

New Call-to-action

Conversations

Archives

see all

Subscribe

Disclosure

The information on this website is intended for informational/educational purposes only and should not be construed as investment advice, a solicitation, or a recommendation to buy or sell any security or investment product. Please contact your financial professional for more information specific to your situation.

Certain sections of this commentary contain forward-looking statements that are based on our reasonable expectations, estimates, projections, and assumptions. Forward-looking statements are not guarantees of future performance and involve certain risks and uncertainties, which are difficult to predict. Past performance is not indicative of future results. Diversification does not assure a profit or protect against loss in declining markets.

The S&P 500 Index is a broad-based measurement of changes in stock market conditions based on the average performance of 500 widely held common stocks. All indices are unmanaged and investors cannot invest directly into an index.

The MSCI EAFE Index (Europe, Australasia, Far East) is a free float‐adjusted market capitalization index that is designed to measure the equity market performance of developed markets, excluding the U.S. and Canada. The MSCI EAFE Index consists of 21 developed market country indices.  

Third party links are provided to you as a courtesy. We make no representation as to the completeness or accuracy of information provided at these websites. Information on such sites, including third party links contained within, should not be construed as an endorsement or adoption by Commonwealth of any kind. You should consult with a financial advisor regarding your specific situation.

Member FINRASIPC

Please review our Terms of Use

Commonwealth Financial Network®