Investors are beginning to price in a prolonged trade war as the S&P 500 Index has declined for four consecutive weeks. There had been a consensus view that the recent tariff hike was a trade negotiation, and that a deal with China remained within reach. The lack of discussions with Beijing combined with talk of punitive tariffs on Mexico in reaction to the border conflict has shifted consensus. The first half of the adage, “sell in May and go away” held true, with the S&P 500 recording its third-worst May since 2015 at -6%. Historically, trading volume falls during the summer months. If this holds it could potentially create greater volatility.
While equity markets are beginning to come to terms with an extended trade conflict, the bond market is signaling substantial pessimism. Long rates have collapsed, with the 10-year yield down to 2.12%, the lowest level since before the 2016 election. Much of the yield curve is inverted with the gap between the 10-year and 3-month at -0.21%. Credit spreads have begun to widen, as investor demand has shifted toward a “flight to quality.” There is a growing unanimity among investors that the Fed will cut rates despite their public comments that remain relatively balanced. The Fed futures curve currently embeds a 97% chance of a cut this year with an 80% chance of two or more. A week ago, there was only an 18% chance of a cut in July, and that has jumped to nearly 60% on Monday.
President Trump announced last week the intention to place a 5% tariff on Mexican goods effective June 10 with an escalation of 5% every month (up to 25%) until Mexico “substantially stops the illegal inflow of aliens coming through its territory.” He defended those comments over the weekend arguing that it would help stop illegal immigration, end the flow of dangerous drugs and boost U.S. job creation. Discussions are set to take place this week, though expectations are muted. China is blaming the recent breakdown in trade negotiations on the U.S., citing unreasonable demands. A white paper published over the weekend focused on three preconditions for a deal: U.S. must remove all additional tariffs on Chinese exports, Chinese purchases of U.S. goods should be realistic, and text of final agreement should be balanced.
Global Economy: The positive momentum experienced in the global economy in March and April has faded, with PMI data showing many economies in contraction. China’s manufacturing PMI reading of 49.4 (below 50 is a contraction) compared to 50.1 in April. Weakness was seen in new orders, production and employment with both imports and exports contracting at an accelerating rate. Eurozone manufacturing PMI was 47.7 in May, equal to last month and the lowest level in six years on slumping orders and pessimism on the outlook for demand.
Investor Sentiment and Activity: Investors continued to adopt a “risk off” approach with $10.3 billion in outflows from global equity funds. This brings the year-to-date total outflows to $145 billion. Domestic funds were the bulk of the outflows, losing $8.4 billion. Emerging market equities saw their sixth straight week of outflows. High yield bond funds fell by $2.8 billion, the fourth-straight losing week. Treasury funds attracted $3.1 billion, the biggest inflows in 20 weeks. Investor sentiment continues to be cautious, as the AAII survey shows 25% are bullish and 40% are bearish. This spread of -15% compares to +20% as recently as May 10. This is the sharpest three-week decline in more than six years.
What to watch
Global news will be important next week, including the ECB meeting, President Trump’s trip to the U.K. and Theresa May’s resignation. Domestic economic data includes ISM manufacturing on Monday, durable goods on Tuesday, ISM services on Wednesday and payrolls and consumer credit on Friday.