Stocktake: Trade war fears hit stocks

It would be a ‘big deal for profits even if it isn’t as big of a deal for the economy’

The escalation in global trade tensions hit stocks last week. Should investors be worried? Certainly, a proper trade war could do real damage. A 10 per cent increase in import costs could reduce S&P 500 earnings by 3 to 4 per cent, Merrill Lynch cautioned last week.

That might not sound drastic, but a corresponding fall in global price-earnings ratios could wipe between 15 and 20 per cent off stock prices, warned Pictet Asset Allocation.

A trade war would be a "big deal for profits even if it isn't as big of a deal for the economy", according to Jeffrey Kleintop of Schwab, which warned in its recent mid-year outlook that a trade war was the biggest risk facing global equity markets. The good news is most strategists agree that a full-blown trade war remains unlikely. Although the rhetoric coming from the Trump administration is "pretty wild and heated", the reality has been "pretty mild", says Kleintop, who notes the US "has backed down again and again from some of these more wild negotiating positions". Still, while the base case should be that common sense prevails, the question is when. For Trump, some strategists suggest it would make political sense to announce some sort of a resolution (billed as a victory) in October, shortly before November's US mid-term elections. Markets would prefer this issue to be put to bed sooner rather than later, but investors should brace for more heated rhetoric in the coming weeks.

Will trade tensions hit earnings?

US earnings season has begun and is about to really get under way on July 13th, when big banks like JP Morgan,


Wells Fargo



report. It’s reasonable to assume analysts will be keeping a close eye as to what companies have to say about the potential impact of those aforementioned trade tensions on corporate earnings. A fortnight ago, German car maker


suffered its biggest one-day share price fall in months after becoming the first major company to cut its earnings outlook due to increasing trade tensions.

Weakness in European and Chinese stocks are testimony to investors' anxiety over trade, as is the recent marked underperformance in trade-exposed companies like Caterpillar and Boeing. Of course, a little cynicism wouldn't go amiss at times like this. Many firms might need to cut forecasts for their own company-specific problems; trade difficulties, as CLSA Securities strategist Nicholas Smith noted recently, represent "an incredibly convenient reason to blame it on".

Nervous investors pull money from Europe

Global investors are getting increasingly iffy about Europe. Although global equity funds have just seen their biggest weekly outflows in nearly three years, 2018 has nevertheless been a decent year in terms of fund flows, Barclays noted last week. Investors have poured $133 billion into global stock funds, with positive fund flows in the US, Japan and emerging markets.

Europe has been very much the laggard, however, with investors pulling $23 billion from European stock funds. Notably, European funds have seen 15 consecutive weeks of outflows – the longest such streak since 2016. Clearly, fears of a growth slowdown and trade tensions have hit European sentiment, although contrarians shouldn’t get too excited. Defensive positioning remains “close to extreme underweights”, with investors preferring cyclical stocks, particularly technology – 59 per cent of European funds are overweight the tech sector. Barclays’ data echoes the most recent Merrill Lynch monthly fund manager survey, which indicated investors have soured on Europe but not yet given up it.

A change in the market trend?

Last week’s market selloff drove the Dow Jones index below its 200-day moving average for the first time since 2016. Does this indicate the equity market uptrend is in danger? The question is slightly premature, given that the S&P 500 – an index which is much more representative of the US market than the Dow – remains just above its 200-day average.

That aside, stocks have historically done much better when trading above their long-term moving average. The annualised return of the Dow after closing above its 200-day average is 9.7 per cent, according to Pension Partners' Charlie Bilello, versus a loss of 3.2 per cent for closes below it. Stocks have also been much more volatile when below their long-term average, notes Bilello, while most of the worst days in market history have occurred at such periods. However, there's no cause for panic just yet. Academic research shows a simple trend-following strategy – buy when stocks are above their 200-day average, sell when they fall below – was a winning strategy during the 20th century before it abruptly stopped working in the 1990s. In fact, market historian Mark Hulbert notes that over the last 25 years, investors would have earned more money by buying at such junctures rather than selling. Investors are worried by various issues at the moment, but there's no need to add the apparent deterioration in market technicals to the list.