Markets consolidate with continued trade uncertainty
Equity markets have entered a consolidation phase, with the S&P 500 Index falling for two consecutive weeks after hitting an all-time high. Investors are struggling to balance an improving macro backdrop against the likely headwinds from the expanding trade war.
Economic data continues to be encouraging, with the index of leading indicators up 2.8% from a year ago. Since 1970, each recession was preceded by a negative reading on leading indicators, and only once (January 1996) did a negative reading not lead to a recession. In May, consumer sentiment surged to the best level in 15 years and the NFIB Small Business Index surprised to the upside (103.5 vs. 101.8 last month). Despite the strong data, economist surveys show an increasing likelihood of a recession by the end of the year, currently at 40% up from 35% last month. Also, the Fed futures curve embeds a 73% chance of a rate cut this year (31% of two or more cuts) despite firming data as the trade situation with China deteriorates.
Discussions with China took a negative turn this week with China retaliating against the increased tariffs by imposing tariffs on $60 billion in U.S. goods. Conversations are still ongoing, but President Trump has told advisors that he has no intention of dialing back on the trade war. Trump took aim at Chinese telecom companies, Huawei and ZTE, on Wednesday when he signed an executive order labeling them as engaged in activities contrary to U.S. interests, requiring government approval for sales or transfers of technology. As a likely coincidence, China sold the most Treasuries in almost two years in March, cutting their share of ownership to 17% of total, down from 28% in 2011. The U.S. announced that it would lift steel and aluminum tariffs on Canada and Mexico in favor of stronger enforcement actions, a move that may clear the way for the USMCA trade agreement to be ratified. This, along with the delay of implementation on auto tariffs by six months, provides some relief against the negative impacts of the escalation with China.
Global Economy: Rising trade uncertainty has yet to impact global economic data, with first-quarter GDP growth in Japan unexpectedly surprising. The 2.1% annualized rate compares with expectations for a 0.2% contraction and 1.6% growth in the previous quarter, driven primarily by a rise in net exports. European Parliament elections this week will be an indicator of whether anti-establishment parties take control after a 40-year run where establishment parties led.
Technology Sector: The technology sector has been a dominant performer this year, returning 22% versus 15% for the S&P 500. There are some signs of a transition, as some “high-flying” tech names have struggled in the past month. The S&P 500 High Quality Index has outperformed the High Beta Index by nearly 5% over the past month and by 13% over the past year, as investors have begun to position more towards safety as the business cycle ages. Also, rising trade tensions is a headwind for the tech sector that drives nearly 60% of revenues from outside the United States. The action taken last week against Huawei and ZTE could result in retaliation from Beijing, which could negatively affect the technology sector.
Sentiment: Investor sentiment and fund flows have deteriorated substantially in recent weeks despite the S&P 500 being within 3% of an all-time high. Lipper reported equity fund outflows of $12.3 billion in the most-recent week, the fourth consecutive week of outflows. Equity ETFs had outflows of $10 billion for the second straight week, marking the second and third-worst weeks of the year. Money market funds continue to grow, with $14.5 billion in inflows. Investor sentiment fell substantially this week, with the CNN Fear& Greed Index dropping to 37 on a scale from 0-100, while the AAII survey showed bulls falling 13% to 30% and bears jumped 16% to 39%.
What to Watch
Notable economic releases next week including existing home sales on Tuesday, PMI data and new home sales on Thursday, and durable goods on Friday. The minutes from the recent FOMC meeting will be released on Wednesday. European Parliament elections this week could give a signal on geopolitical risk.