Add trade tensions and the threat they pose to economic growth to the list of worries that were already dogging stock-market investors in 2018.
President Donald Trump’s announcement Thursday that he was set to impose tariffs on aluminum and steel imports sent stocks tumbling. Weakness continued Friday morning, with stocks opening sharply lower before rebounding off lows, with the S&P 500 SPX, +0.51% taking back some of the previous day’s decline while the Dow DJIA, -0.29% ended lower for a fourth straight session.
While underlying fundamentals remain strong, investors said the threat of a trade war adds another layer of uncertainty to existing concerns about inflation and the prospects for long-term growth.
“For now, the more predictable forces of tax policy, fiscal policy, and monetary policy are overshadowed by the incendiary news flow and protectionist rhetoric,” said David Kotok, chairman and chief investment officer at Cumberland Advisors, in a Friday note.
The announcement drew angry responses from global leaders, with the European Union weighing retaliatory tariffs on $3.5 billion worth of U.S. imports, according to Reuters. Meanwhile, Trump doubled down, tweeting that “trade wars are good, and easy to win.”
It’s the economy
The broad-based nature of the tariffs—and the broad-based market reaction—indicate that “investors are not only concerned about this particular action, but also how that’s going to affect the economy in the U.S.,” said James Norman, president of QS Investors, in a phone interview.
After all, not only did the news hit heavy users of steel and aluminum, like Boeing Co. BA, -1.44% and Ford Motor Co. F, +1.07% , on Thursday, he noted, but other cyclically-sensitive areas, such as tech stocks, health care and consumer cyclicals.
Domestic U.S. steel prices were already up 20% since the beginning of the year in anticipation of possible tariffs, said Andrew Hunter, U.S. economist at Capital Economics, in a note. That’s a big potential drag on steel consumers in the machinery, motor vehicle and construction industries, he said, observing that the tariffs could, ironically, raise the incentive for those manufacturers to move production offshore to avoid the tariffs.
More uncertainty means…
The threat of retaliation by trade partners is also a concern, potentially creating a spiral that could undercut global economic growth, widely seen as a key ingredient in the stock market’s 2017 rally.
That was part of the “Goldilocks” backdrop for equities, along with subdued inflation pressures and confidence in the monetary policy outlook, which also contributed to a stretch of extremely low market volatility.
Over the past month, that’s been eroded by worries over a potential pickup in inflation and uncertainty over monetary policy. And volatility has also increased. The Cboe Volatility Index, or VIX, -12.82% , which measures expectations for S&P 500 volatility over the next 30 days, jumped sharply on Thursday and again on Friday to trade above 25 before pulling back to end 2.88 lower at 19.59, near its long-term average. The index, however, rose 18.8% this week.
“If you throw into that uncertainty about trade policy and how that might impact economic growth, then that increases uncertainty. And that’s why I think you’re seeing this volatility uptick,” Norman said.
Also, there’s uncertainty over the fate of Gary Cohn, Trump’s top economic adviser. Politico reported that the tariff decision came after a frantic 24 hours in which Cohn and others tried to talk Trump out of taking action.
Stocks temporarily dipped in August amid speculation that Cohn would leave the White House in reaction to Trump’s remarks following deadly violence at a white-supremacist rally in Charlottesville, Va. Cohn’s potential departure could underline fears that economic policy would be dictated by nationalist advisers, economists said at the time.
Kotok said rising tensions are “either setting up a massive buying opportunity in U.S. stocks—which is what we believe—or it is setting up an economy that will be forced into recession by protectionism (which we do not believe).”
“Either outcome has become less predictable. Trump has raised risk premia in all markets,” he said.
While stocks should benefit from a positive economic backdrop, investors should be prepared for a more normal volatility environment—and occasional volatility spikes—as they come to grips with the end of the ultralow volatility regime that prevailed until early February, Norman said.
Investors should probably lean away from more cyclical shares and toward a more defensive equity income strategy, he said, focusing on companies that have less volatile earnings, which can lead to more stable income production in terms of dividends.