A Red, White, And Blue Stock Market

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Includes: DIA, IWM, QQQ, SPY
by: Markos Kaminis

Summary

Red is the color of the economic impact of trade war.

White is the color of the flag consumers will waive globally because of trade war.

Blue is how investors might feel as equities bear the weight of trade war worries.

On Independence Day this year, I could not help but to make an analogy about the red, white and blue of our nation’s flag, and how the stock market today displays those same “colors.” It is red because of the economic impact of a bloody trade war. It is white because consumers will waive the white flag in a trade war with no victor. It is blue because stocks have been kept from fully enjoying an opportunity for greater gains because of very relevant trade concerns.

The Red Economic Impact

The President’s efforts to attain better trade deals have thus far been met by a tit-for-tat trade scuffle between the United States and its trading partners. So-called reciprocal trade actions, with tariffs on foreign imported goods being met by counter tariffs employed by affected nations and groups of nations present a vivid illustration of an escalation toward a broader trade conflict.

Such a scenario could bring into play more lethal weapons. In other words, the somewhat limited tariffs we have seen employed thus far on select commodities and goods could expand to include broader reaching, let’s say, weapons of mass economic destruction. Perhaps the United States might tax all imports from the European Union and vice versa. Or what if China allows its currency to devalue to counter the impact of tariffs, or if China declares it is considering reducing or stopping purchases of U.S. treasuries? Today, these are only ideas of pure speculation, but tomorrow they could be reality in a bloody trade war.

Wars, and trade wars, do not start out as full on, all-out, bloody battles of entire nations and groups of nations. Rather, they begin with a spark that grows into a small fire before going out of control. Enactments of tariffs, say like the United States’ decision to tax imports of steel and aluminum, may be the first non-lethal steps toward more significant conflict.

We run the risk of a bloody mess, because our counterparts across the world may not react like we intend or expect them to, assuming we expect them to fall in line and quickly agree to trade deals that are less favorable to their peoples and more favorable to the United States. That is what we expect because of the importance of the U.S. to the global economy. Perhaps, though, they will seek to stop our current path via the use of more impactful or effective measures, like those mentioned above. A bloody mess may ensue as tit-for-tat evolves into blow-for-blow.

The White Flag of the Global Consumer

Nobody wins in war, or in trade war. Yes, there tends to be a winner on paper; but, the peoples of nations globally literally pay the price of trade war, and U.S. citizens will not be excluded. We are unnaturally raising the prices of goods and services, setting in place the fuel for a furious inflation fire. When unnaturally higher priced goods and services impede the purchases of those goods and services by a significant number of consumers, the economic impact will be unmistakable.

Furthermore, when the U.S. places tariffs on imported metals, it raises the impute price of finished goods and services using those metals. While U.S. producers of steel and aluminum may be made more competitive temporarily, and will profit from the change, every other producer of goods incorporating those metals pays the price. In turn, those producers (say of homes, autos or beer) have a choice to make: raise the price of their finished products, while hoping demand is strong enough to bear the cost; or bear the cost themselves, and see their earnings growth and expectations reduced.

There is a great potential cost to pay, as an unnecessary threat to the current economic revival is set in place to stunt growth. And if it comes, it comes just as I was expecting the economy to enter a boom period. Without the bad scenario of full fledged trade war, I saw the U.S. economy enjoying two great years of exceptional expansion. Incorporating the worst-case scenario of trade war, it could be cut short to six months. Consumers globally can only bear so much inflation, and central banks will only endure so much, despite the current solid labor and economic situation, especially in the U.S.

The Blue Stock Market

The stock market is blue because it is not maximizing its opportunity to lever exceptional economic strength. CNBC’s Rapid Update shows economists expect U.S. GDP to expand 3.9% on average in the second quarter of 2018. This follows 2.0% growth in the first quarter and 2.9% growth in the fourth quarter of 2017. The benefits of tax reform legislation, a fully employed U.S. labor market and a global economic revival are immense, but are they currently reflected by the stock market?

Following an exceptional 2017 thanks to pro-market promises by the Administration after the election, stocks started 2018 off in extraordinary fashion through January on the passage of U.S. tax reform. But, before long, trade and tariff rhetoric and actions began to weigh against equities, especially those in the S&P 500 and the Dow Jones Industrial Average. You can see in the chart of the SPDR S&P 500 (SPY) here that despite strong economic data, shares of large multinationals have gone nowhere this year, though under intensified volatility. The SPY is up just 2.5% year-to-date, while the SPDR Dow Jones (DIA) is down 0.9%. Though, the Invesco QQQ Trust (QQQ), which tracks the Nasdaq 100, is up 10.6%, and the iShares Russell 2000 (IWM), which tracks small-cap stocks with a domestic business focus, is up 7.7%.

Chart SPY data by YCharts

While it remains unclear just how the trade tirade will develop, whether it will cause a regression of global civilization, so to speak, or lead to better deals for America and Americans, at least for now the former seems to be the case. It’s my view that if the Administration were to call a ceasefire, stocks would quickly rally to new highs.

The current P/E ratio of the S&P 500 is above its historical average, but it’s my view that earnings per share growth will also exceed historical averages and justifies a higher than average market valuation now. We can see here that the forward P/E ratio of the S&P 500 Index is 17.2X, reflecting strong forward earnings expectations that I believe are probably understated, so an elevated current P/E ratio is probably justified. And if we take away some of the blocks in the wall of worry, especially those relative to trade war concerns, I expect investors would bid stocks higher.

Conclusion

It’s a red, white and blue stock market, appropriately so I suppose through this patriotic season, because of the trade war weight against equities. While we cannot say conclusively if a worst-case scenario will play out, given our lack of insight into the complex strategy of the Administration and U.S. trading partners, and how far they are willing to go, we can say the economy, consumers and stocks are bearing, or will bear, a cost. For more of my regular coverage of markets, the economy and securities markets, readers are welcome to follow the column here at Seeking Alpha.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.