Stocks sell off as trade war intensifies

Markets sold off heavily on Monday, following a sharp escalation in the China-U.S. trade war. Both the Dow Jones Industrial Average and the S&P 500® plummeted roughly 3% as China retaliated to U.S. President Donald Trump’s tariff threat.

A quick escalation

Trump’s announcement last week that the U.S. plans to impose a 10% tariff on the remaining $300 billion of Chinese imports not already being taxed was almost certain to draw a swift response from Chinese leaders. Sure enough, that’s what transpired.

Over the weekend, China struck back at the U.S. by devaluing its exchange rate by  approximately 1.5%, with the yuan-to-dollar ratio falling below 7-to-1 in offshore trading today. In addition, the country instructed state-owned enterprises to stop buying U.S. agricultural products. Both of these measures are likely to draw even further ire from President Trump. Why? He has been an outspoken critic of Chinese currency manipulation in the past, and was reportedly also angered by China’s failure to follow through on its recent promise to increase U.S. agricultural purchases.

Why are markets so concerned? 3 reasons: Earnings, consumer spending and jobs

The rapid escalation in the trade war between the two countries almost guarantees a prolonged period of trade uncertainty, with the potential for the Trump administration to raise tariffs even further in the fall. We believe this may lead to potentially significant impacts for:

  1. Corporate earnings
  2. Consumer spending
  3. The U.S. labor market

Earnings outlook deteriorates

Simply put, tariffs weaken corporate earnings because they result in an increase in input costs. More tariffs on more products equals higher input costs. One need look no further than the second-quarter earnings season to see this. While companies have done a bit better than expected, earnings growth for the S&P 500® Index is tracking around -1% according to FactSet data. In our view, the increase in trade tensions makes a sustained earnings recession (defined as two consecutive quarters of declining earnings) much more likely. In addition, an industrial recession in the U.S. also appears increasingly probable, as manufacturing activity continues to slow, and appears on the verge of contracting already.

Consumer spending in jeopardy

Consumer spending, alternatively, has remained strong so far, despite the tariffs that the U.S. has already placed on $250 billion worth of Chinese goods. This, however, may change if the latest round of threatened tariffs go into effect. Why? The latest imports targeted by the Trump administration consist mostly of consumer goods, such as mobile phones and toys. Once again, businesses will be forced to either absorb the additional cost or pass it on to consumers. With corporate earnings already blunted by the trade war, it’s not hard to fathom the latter occurring this time around. The impact of a slowing consumer could be material, given that consumer spending accounts for 70% of the U.S. economy.

Job growth at risk

The escalating trade war also has the potential to detrimentally impact the U.S. labor market, which has already seen a modest slowdown in job growth from last year. Waning CEO confidence has already led some business leaders to scale back on capital-goods purchases. Typically, in a situation like this, the next thing CEOs tend to cut back on is hiring.

Investment strategy

As the trade situation sours, downside risks to the global cycle have increased in the near-term. In our opinion, this makes a third U.S. Federal Reserve (the Fed) rate cut likely this year. At current yield levels we have a neutral to slight overweight preference for U.S. duration in multi-asset portfolios. The equity market selloff looks commensurate for the increased risks to the outlook. We are not inclined to add to risk positions here as we do not yet see compelling evidence of a broad-based investor panic.

Bottom line: Our preferred positioning is to continue to hold asset allocations near policy with an eye towards defensiveness. 

Any opinion expressed is that of Russell Investments, is not a statement of fact, is subject to change and does not constitute investment advice.