Stocks plunged Monday on fears the trade war will now last longer and escalate further, damaging the global economy and crushing corporate profit growth.
Large cap stocks, or those in the S&P 500, have now lost $1.1 trillion since President Donald Trump surprised markets with the May 5 weekend tweets that said he was thinking of raising tariffs on Chinese goods.
As China retaliated against the latest U.S. tariffs Monday, the Dow and S&P 500 were both down more than 2% in their worst day since Jan. 3. Investors fled to bonds and other safe haven trades, like gold.
Market strategists predict more pain for stocks ahead, as the market prices in a more extended view of the trade battle that looked to be just a skirmish a week ago. Since his weekend threat, President Donald Trump forged ahead with higher tariffs on $200 billion in Chinese goods and says he will move forward with new tariffs on all China imports, goods totaling about $325 billion more.
China retaliated by raising tariffs on $60 billion in goods. As of June 1, Beijing will increase tariffs on more than 5,000 products to as high as 25%. Duties on some other goods will increase to 20%. Those rates will rise from either 10% or 5% previously. Products hit by the 25% tariffs include animal products and frozen fruits and vegetables. Chemicals are among goods to be taxed at 20%.
“Our view is this could escalate for at least a matter of weeks, if not months, and it’s really to get the two back to the negotiating table and finish the deal, is probably going to require more pain in the markets…Really the only question is if we need a 5%, 10% or bigger market correction,” said Ethan Harris, head of global economics at Bank of America Merrill Lynch.
The Dow, at its low, was down more than 700 points. The Dow closed down 617 points at 25,324, while the S&P 500 was off 69, or 2.4% at 2,811. The Nasdaq was down even more, losing 269 points or 3.4%, as the sell-off was led by tech and other industries sensitive to U.S.-China trade. Tech was down as much as 3.7%, while industrials were down 2.8%.
As stocks sold off, investors ran to the safety of Treasurys, and the 10-year yield fell to 2.39%. At the same time, the futures market was pricing in a full 25-basis point Fed rate cut for this year and most of one for next year, according to BMO.
Where’s the bottom?
Julian Emanuel, head of equities and derivatives strategy at BTIG, said the market could have further to fall, and he doesn’t expect it to stop until the CBOE’s VIX, a measure of puts and calls, rises to 30. The VIX, commonly viewed as a fear meter, was up 32%, just above 21.
“We see downside risk to 2775, the S&P’s 100-day moving average, more importantly 2,600 is an area of previous support,” said Emanuel. A decline to 2,600 would be about 7%. “Trying to pick a level in the market is much more difficult. What we really want to see is a degree of fear. To us that degree of fear right now is represented by the VIX trading up to 30, which we think will happen at some point in the near to medium term.”
Emanuel said some chart analysts see a potential double top in the S&P, a negative sign for stocks, and there are unresolved divergences among indexes. For instance, the small cap Russell 2000, the Dow and the Dow Transports never recovered their highs, as the S&P 500 reached an all-time high May 3. Since then, it lost more than 5%.
Market sentiment sours “when you combine [trade] with the threat from Iran and the idea of EU parliamentary elections which begin May 23 and could bring the right wing nationalists into more focus, plus the psychological damage that occurred at the highs when the Fed was viewed as being less supportive than the market believed, plus the divergences.”
He expects the S&P 500 to reach 3,000 by the end of the year, but he does see the Fed cutting interest rates and that will help market sentiment even before the central bank acts. The Fed, itself, says it is on hold this year, and Fed Chairman Jerome Powell and others have indicated the Fed does not see a reason to cut rates for now.
Many investors believe the Trump ‘put’ will prevent the market from falling too much. The so-called ‘put’ is the belief that Trump will take action of the stock market is falling too much.
“The problem with the Trump put is it stretches out the battle,” said Harris. “You can’t trigger the put without the market going down and so, ironically, the belief in the Trump put stretches the whole brinksmanship battle out further. You have to kind of think of this as a back and forth between the markets and the policy makers on both sides.”
Harris notes that the latest round of trade talks came together, just after stocks collapsed in the last week of December.
Emanuel said the stock market is reacting to the fear that trade war will now be extended enough to do more and deeper damage to the economy, particularly if more tariffs are launched or China finds other ways to hurt U.S. companies on its home turf.
“The whole idea that you could skate through the trade war with no adverse effect, we already saw the adverse effects in the fourth quarter of last year in the stock market,” Emanuel said. “In our view, it’s actually been an adverse affect in the first quarter of 2019 with this massive plunge in yields in the U.S. as a result of global weakness in the bond market which reinforces the disinflationary mindset of the Fed.”
Over the weekend, Trump continued to tweet about China, blaming it for the breakdown that has delayed a deal that was expected this month.
Harris said both Trump and China’s President Xi Jinping, no doubt, feel emboldened to keep the war going because of improved economies and stock market gains since the beginning of the year.
“It’s probably slicing a few tenths off of U.S. growth already. We haven’t decided how far this will go. Claerly the downside risk just escalated significantly, even without the next round,” he said. Harris said two big rounds of tariffs are still possible—tariffs on the global automobile industry and the final $325 billion Trump is threatening on China.
Economists expect the hit on China’s economy to be bigger at about a half percentage point of growth, and more if the next wave of tariffs is instituted. Goldman Sachs economists said if the trade war escalates the impact to U.S. growth could reach 0.4 percentage points.
“The problem is if you let enough time pass, you’re going to set forth a sequence of events in global economies, in terms of creating a slowdown, that isn’t going to correct itself by simply saying the tariffs are done,” said Emanuel. He said there’s also part of the first quarter’s 3.2% growth that was inflated partially by a build in inventories. He said there could be pay back for those inventories in the already slower growing second quarter, which is under 2%. Those inventories were accumulated when it looked like an end was coming to the trade war and inventories would be used, he said.
“There’s a difference between talking about things and putting your signature on a contract. I think there’s ultimately gong to be a deal, but it requires more back and forth. The irony here is if the markets don’t respond or continue to respond, the trade war just continues,” said Harris. “If everything is calm for awhile, they’ll hunker down into their trenches and battle away. I do think it requires more of a sell off in the markets.”
Three options strategies for the week: May 20, 2019
Trade war may be losing its power to frighten resilient stock market
The stock market has so far withstood its ongoing “gut check,” with a three-day bounce after last Monday’s mini-tariff-panic sell-off, preserving its longer-term uptrend and leaving the S&P 500 about 3% from its recent record highs.
Still, for a market so close to all-time heights, its resilience to date owes a lot to cautious, risk-evading behavior rather than optimistic conviction about the future.
Stocks have been supported to a significant degree by compressed Treasury yields, which themselves embed high market-implied odds of a Federal Reserve interest-rate cut within months. Such a move by the central bank would come about only in response to waning economic momentum and a rollover in inflation trends.
Here, Bespoke Investment Group illustrates the way the S&P 500 has lately failed to follow 10-year Treasury yields down after tracking them fairly well for a while.
There’s nothing ironclad about the interplay of equities and bond yields — the relationship shifts across market phases. But this at least shows stocks have found a way to hang above the 2,800 zone — once viewed as the ceiling of a sloppy, treacherous trading range — as Treasury yields have succumbed to a global risk-aversion impulse.
What are investors betting on?
One way the S&P has managed this is to lean heavily on more stable, less cyclical stocks. This means turning back toward the familiar favorites of FANG — those organically growing, software-powered giants with fewer bets on China and less sensitivity to macro headwinds.
The FirstTrust Dow Jones Internet ETF (FDN), a good proxy for FANG-type stocks, is up 21% this year to 14% for the S&P 500. The iShares Software ETF (IGV) is ahead by 24% for 2019. Since the day exactly two months ago when the 10-year Treasury broke down below 2.6% toward its current 2.39% level, IGV is up 2.9% to the S&P’s 1.2% gain.
Another popular hiding place is “low-volatility” stocks — stable companies’ slower-moving shares, which act somewhat like bonds. Here’s the Invesco S&P Low-Volatility ETF (SPLV, in red) against the S&P 500 (green) and the Invesco S&P High-Beta ETF (SPHB, blue) over the past month. In other words, the stock market has been held up by stocks that behave less like stocks than most stocks.
Aside from sector divergences, the small-cap Russell 2000 continues to underperform badly, while the rise in risk-aversion can also be seen in the Japanese yen and Swiss franc moving higher in recent weeks.
In a way, the strength in steadier, blue-chip U.S. stocks is not inconsistent with sinking global bond yields and gains in safe-haven currencies. On some level, large-cap American equities are on the same “relatively expensive but higher quality” end of the asset spectrum.
The tariff escalation could easily be viewed mostly as an excuse for a standard shakeout after a 25% rally since December, just in time to keep complacent investor sentiment and positioning from stretching all the way to extreme and self-undermining overconfidence.
Two choppy, headline-tossed weeks for stocks have gone some distance toward moderating gathering mood, with a risk-shunning attitude evident in investor surveys and fund flows.
While a bit fickle and narrowly sampled, the weekly American Association of Individual Investors poll showed one of the eight largest jumps in bearish respondents in a decade, with more bears than bulls.
This is echoed by significant drops in optimism in professional-investor sentiment gauges kept by Consensus Inc. and Market Vane toward neutral readings from multimonth highs just two weeks ago.
Outflows from equity mutual and exchange-traded funds has been more the rule than not this year, suggesting the fourth-quarter collapse in stocks has had a lasting effect on investor attitudes.
Ned Davis Research shows this heavy pace of withdrawals against the S&P 500, which goes down as a bullish factor from a contrarian perspective.
The latest flare-up in trade friction with China has rubbed a raw nerve among investors, who explained stocks’ steady climb through April as a story of big threats fading from view: The onrushing recession feared in December is not in evidence; the Fed has backed away from rate hike plans; corporate earnings arrived better than forecast; and, until two weeks ago, the U.S.-China trade tussle looked near a benign resolution.
After last Monday’s 2.5% sell-off, stocks showed signs of again trying to set aside the trade issue, which — for all its drama over the past two years and the high perceived stakes — has not been able to hold the market hostage for long stretches of time.
The bounce that started Tuesday allowed the S&P to narrow its weekly loss to 0.8%. On a net basis, the market was up during regular trading hours, with overnight weakness dropping the indexes at the open, only to have buyers pick them up in the regular session.
The makeup of the rebound was not all that impressive, granted. Market breadth continues to lag a bit, with fewer than half of all S&P 500 stocks in a technical uptrend, to cite one soft spot.
(It was the fourth straight negative week for the Dow, and there have not been five straight down weeks for the index since the 2011 minibear market, so the odds hint at some short-term relief.)
The market continues to track the 2016 path, in broad terms: a brutal minibear market gives way to a more dovish Fed and huge stock market rebound even as bond yields stay low, defensive stocks lead and investor sentiment stays muted.
Several months after the early-2016 market bottom, the Brexit vote shock administered a stiff and scary test, proving good enough for only a sharp, brief sell-off before stocks resumed an upward grind. Could the trade-war scare of May prove a similar geopolitical test that doesn’t get “resolved” but loses its power to frighten investors so readily?
This is a notion investors need to ponder but the market will have to prove or refute.
Hotshot active fund managers will soon have a way to play the ETF game
Pedestrians walk past the New York Stock Exchange before the closing bell in New York.
Bryan R. Smith | AFP | Getty Images
A new kind of exchange-traded fund is expected to grant active money managers a way to offer their strategies without divulging their stock picks and methods, a key hang-up that’s kept them from participating in the booming industry.
ActiveShares, a product designed and built by Precidian Investments, received word from the Securities and Exchange Commission on April 8 that its so-called nontransparent ETF model should be approved.
Nontransparent ETFs would mask the underlying securities of the fund but still allow investors exposure to the portfolios arranged by Wall Street’s top stock pickers. Industry analysts also anticipate the funds will reduce key fund expenses and grant tax advantages — just like other ETFs.
Though Precidian is still awaiting a final order from the SEC, founding principal Stuart Thomas told CNBC the product is the first of its kind and could someday impact the entire mutual fund industry.
“At the end of the day, it looks, smells and feels like an ETF because it is an ETF,” Thomas said. “You’re taking actual slices of the portfolio — anytime there’s a creation or redemption in their appropriate weightings — and that’s what the authorized participant is delivering to the fund in exchange for ETF shares.”
“There’s nothing complicated, it fits perfectly within the ecosystem,” Thomas said of the ActiveShares model. “Trading, settling, reporting, monitoring: All the existing strategies the trading desks use today can be applied to this structure.”
ActiveShares could represent a big opportunity for a generation of active managers that have seen their assets evaporate at the hands of low-cost, passive alternatives drawing in big investor dollars.
At the end of April, passive U.S. equity fund assets reached parity with active U.S. equity funds at $4.3 trillion each, nearly 13 years after actively managed U.S. equity funds saw their last calendar year of net inflows and amid one of the longest bull markets ever, according to Morningstar Direct research.
But the new nontransparent funds could offer a way to recapture investor dollars, says J.P. Morgan analyst Kenneth Worthington.
“Precidian’s non-transparent ETF is a potentially crucial structure in the evolution of the actively managed mutual fund industry, as it holds the potential to deliver greater tax efficiency and meaningfully lower costs to fund investors,” Worthington told clients in a note Thursday.
‘Levels the playing field’
Part of the reason ETFs are so popular is their tax advantages compared with the traditional mutual fund model.
As long as the index an ETF tracks doesn’t see frequent changes to its composition, the funds themselves rarely have to adjust their portfolio to match. Also, when market makers redeem ETF shares, they receive securities instead of cash, further shrinking the need for the fund to declare gains.
“We see retail investors as long-term beneficiaries, and exchanges and trading firms stocks as being helped,” the analyst wrote. “We also think the structure levels the playing field somewhat between passive and active investing.”
“Potential linkages of ETFs and mutual funds could enhance the tax profile of existing mutual funds, making the products ‘must-haves’ for mutual fund companies,” he added.
Worthington sees T. Rowe Price in particular as a potential beneficiary of the new structure. Given its its size and relative success over the long term, the analyst said, it may be able to attract money from the passive side if it adopts such a model. The mutual fund manager has applied for a similar ETF structure with the SEC.
“We believe the Precidian approval is good news for those, including us, with proposals for semi-transparent ETFs in front of the SEC, and for investors,” T. Rowe told CNBC in an emailed statement. “We have more work to do to get our application through the SEC, and our ongoing conversations with the SEC staff continue to be constructive.”
Precidian’s Thomas has a history of innovating in the fund world. A Morgan Stanley and Merrill Lynch alum, he started World Gold Trust Services in August 2002. At the direction of the World Gold Council, he created, managed, and marketed the first U.S. commodity-backed equity traded on an exchange.
That ultimately evolved into SPDRGold Trust, the first U.S. traded gold ETF and the first U.S.-listed ETF backed by a physical asset. The Precidian team, which includes Daniel McCabe, Mark Criscitello and Paul Kuhnle, is also responsible for building the first currency-backed ETFs in the U.S. with Rydex. That platform is now owned by Invesco under its CurrencyShares suite.
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