Stocks Crater On Tariff Announcements

Stocks Crash & The Long Bond Rallies

Thursday was a horrible day for the stock market as the S&P 500 fell 2.52%. It is now down 7.98% from the all-time high. It’s only up 2.43% from the correction bottom in February. The market is now down for the quarter which is over next Friday. The VIX was up 30.68% to 23.34. The 10 year yield was down about 6 basis points. With the movement to start the day on Friday, the 10 year yield has pushed below the March 1^st closing low. Stocks are falling and bonds are rallying. The 2 year yield fell about 3 basis points, meaning the curve flattened. The difference between the 10 year yield and the 2 year yield is 54 basis points.

The dollar index fell slightly as it is now only 1 handle above its February bottom. Stocks are falling along with the dollar because tariffs hurt America’s standing in the world and hurt corporate profits. Oil was down 1.3%, continuing its high correlation with stocks. I don’t have a high level of confidence in the CNN Fear and Greed index, but I do find it interesting. The reading is now at 9 out of 100 signaling extreme fear. It’s at almost the same reading where it was when stocks bottomed. The more panic in the market, the better for future returns. It’s now common to see analysts expecting stocks to have little returns before the next recession in 2-3 years. The more this becomes consensus, the better buy the stock market becomes.

Tariff Battle Begins

I don’t want to call this a trade war, but skirmishes have broken out between America and China.  That’s the main catalyst which sent stocks falling. As you can see from the chart below, the fund managers were correct when they named a potential trade war as the biggest tail risk since the market saw volatility because of new tariffs on Thursday. I think the inflation answer is too popular because inflation isn’t even at the Fed’s 2% mandate. The market went from worrying about deflation to inflation in a matter of 24 months even though there hasn’t been much change to inflation.

The trade skirmish news on Thursday was that Trump will put a tariff on $60 billion worth of Chinese imports. This was rumored previously. The statement which really hurt the market was that Trump said this would be the first of many trade actions. I have been of the belief that Trump is talking tougher than he will act, but the fact that he is talking tough while acting adds to his credibility. I can’t tell if this is by design or if he’s just willing to do whatever it takes to cause the trade deficit with China to decline.

U.S. trade representative Lighthizer will announce a list of targeted products that will taxed in the next 15 days. There will be a 30 day period for the public to comment on the tariffs. If a good enough argument is made, I assume the list will be altered. The report will include 1,300 product lines. Some of the products which will be included on the list are aeronautics, modern rail, new energy vehicles, and high tech products.

The goal of these tariffs from an American perspective is to force China to respect America’s intellectual property. If you use game theory, America wants to put China in the position where respecting intellectual property is more advantageous than either doing nothing or taxing American products. If you are a bull on U.S. stocks, you should hope Trump is using game theory rather than trying to get the trade deficit down. Trade would crash if a balance between the two countries was forced.

China Forced To Make A Decision

There are 2 very important details which will determine the outcome of this skirmish. The first is what changes China would need to make to satisfy Trump. When China is deciding its next move, it needs to know what amount of pain is necessary to avoid the tariffs completely. Chinese leaders stated they shouldn’t be penalized for not wanting to buy American products. If the only options are to buy more American products or sell less products to America, China will never agree to a deal. However, I think if China declares it will respect American intellectual property, I think Trump will squash the tariff.

The second detail is whether the Chinese tariffs on American products actually hurt. China won’t do absolutely nothing, but if it puts a small tariff on American goods, it will be the equivalent of nothing. Putting tariffs that are too high on America risks retaliation and the Chinese economy. Putting tariffs too low might encourage Trump to ratchet up American tariffs. This is a lose-lose situation for China which could mean it will acquiesce to Trump’s demand to respect American intellectual property.

China’s First Response Is Retaliation  

The latest news is that China will retaliate to Trump’s tariffs by putting a tariff on 128 U.S. products. This equates to $3 billion worth of products. I think this is a slap on the wrist for America. It will hurt the stocks which have products that are hit with the tariff, but looking at the overall market, this is small. The U.S. tariffs are 20 times what China is proposing. This may mean China is acquiescing to America. It’s interesting to see the stock market down so much on such a small retaliation. The market is worried about further action from Trump. This stock market decline is all about uncertainty.

Conclusion

All things considered, I think the decline on Thursday was overdone. The Chinese retaliatory tariff was small and Trump’s tariff was already known. I’ve been saying the market will stay in its range until the economy improves. That’s now a bullish perspective because the market has about 2% to fall before the correction bottom. I don’t see a bear market coming because even though the economy is weaker than the 2^nd half of 2017, a recession still isn’t coming. Earnings also still look good.