Risk Horses Gallop as China Lets Currency Fall, Intensifying Trade War

A cautious tone prevails on Wall Street this morning as the trade war intensifies. Stocks are under major pressure, while “defensive” investments like bonds and gold are on the rise.

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6 min read
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Key Takeaways

  • Stocks begin the week under heavy pressure as trade war intensifies
  • Cautious tone prevails, with bonds, VIX, gold all rallying
  • Earnings season continues this week with Disney, Uber on calendar

(Monday Market Open) U.S. investors awoke Monday morning to new exchange in the ongoing trade dispute with China. Only this time, it wasn’t an exchange of words, but rather a tweak in exchange rate policy, as China allowed its currency to float above 7 yuan to the U.S. dollar for the first time since the 2008 financial crisis. It was the largest one-day drop in the yuan in four years.

The rise above 7 was more symbolic than anything else, because the yuan had been within a smidgen of that mark late last week. However, the fact that China let it happen sent a signal to the U.S. that it’s ready to push back against the Trump administration’s decision to impose new tariffs.

By letting its currency dip, China makes its products cheaper for overseas buyers, potentially hurting U.S. industries like steel where the two countries compete. To some analysts, the move signaled that China doesn’t expect a trade deal, and that’s probably what’s really behind the big sell-off we’re seeing. China also announced a suspension of U.S. agricultural imports.

The “horses of risk” are galloping today as the trade war ramps up. Stock futures got hammered overnight following heavy losses in European and Asian markets. When risk flares, investors often flee for where they see possible protection, and that often means bonds, the Japanese yen, the Cboe Volatility Index (VIX), gold, and sectors like Staples and Utilities.

The U.S. 10-year yield fell below 1.8% this morning, one sign of investor caution. That’s the lowest it’s been since October 2016. Gold is up nearly 1% to a new six-year high, and the VIX is up more than 17% to above 21. Just a week ago it briefly traded below 12.

In addition, the yen is rising vs. the dollar, and crude oil fell below $55 a barrel, a psychological support level. Speaking of support levels, It looks like the S&P 500 (SPX) is going to fall below its 50-day moving average near 2927, a level that seemed to represent firm support on Friday.

Last week, Technology stocks took a real beating, and they could be in the spotlight again as trade fears flare. Apple (AAPL) gave up all its earnings-related gains and more by last Friday as investors worried about the impact of tariffs on its products. All the FAANG names were under pressure Friday (see more below), and so were semiconductor stocks, another sector that’s pretty vulnerable to trade woes. The Nasdaq (COMP), which is more heavily populated with Technology, took a deeper dive than other major indices Friday.

Other weak sectors could include Industrials and Materials, which contain a lot of multinational companies exposed to international trade and commodities prices. Both Boeing (BA) and Caterpillar (CAT)—two stocks that often are seen as trade barometers—fell more than 1% in pre-market trading Monday.

Consumer Staples, on the other hand, looked strong last week and often do better than other sectors in tough times. However, the average valuation for Staples is roughly equal to the valuation of the high-growth Technology sector, so that could be a potential headwind.

Rate Cut Odds Improve, With Two Now Seen More Likely

As President Trump’s new tariffs loomed and China retaliated, odds of two more rate cuts this year quickly ticked higher, according to CME Group futures, and that’s also probably bullish for stocks. By early Monday, the odds of two or more rate cuts by December stood near 85%, vs. 50% a week ago. A rate cut at the September meeting now looks like a virtual certainty, judging by futures prices, with chances now at 100%.

That could change, of course, between now and Sept. 18, when the Fed makes its decision. However, it’s hard to see the cut not happening unless there’s some sort of breakthrough on a trade deal with China. At this point, that doesn’t seem very likely.

Another thing worth noting regarding interest rates—last week’s rate cut didn’t have much effect on the shape of the yield curve; it just shifted everything downward. The spread between 3-month and 2-year Treasuries—which was already inverted—has gotten even wider. And this morning’s meltdown sent the 2s, 5s, 10s and 30s all down between 8 and 10 basis points. So any Fed governor who voted for a cut in hopes of getting a positive slope on the yield curve was likely disappointed.    

Deeper Thoughts on Jobs Report

Despite the pounding stocks took last week, the jobs report and factory orders on Friday both were pretty close to expectations, even though some other data didn’t look so positive.

Jobs growth was pretty broad-based across different industries. That’s a good sign, with restaurants, business services, health care and education among the leading growth areas. It’s also good to see that so-called “real” unemployment, a broader measure that includes discouraged workers and the underemployed dropped to 7% in July. That’s the lowest it’s been since December 2000. By comparison, that rate reached 17.1% in late 2009 during the Great Recession.

The New York Times did some shoe-leather reporting last week showing many companies across various industries continue to be short of skilled labor and that competition for higher pay is pretty fierce. That’s never a bad thing, especially so far into an economic recovery. The question is whether those pay increases, along with the Fed’s recent rate cut, could start to have an impact on inflation.

The Fed wants a little inflation because the current rate of 1.6% is well below its 2% goal and deflation wouldn’t be good, but too much inflation would possibly slow the consumer demand that’s been driving economic growth. It’s a delicate balance.

And, Yes, It's Still Earnings Season

September is still far away, so let’s look at the week ahead. First, the earnings flow slows down a bit, but the season isn’t over. Uber (UBER) this coming Thursday could be an interesting one to watch, and Shake Shack (SHAK) looms after the close today.

On Tuesday after the close we’ll hear the latest from Walt Disney (DIS), and that’s probably the biggest name on the reporting list for the next five days. Investors are likely going to be tuned into DIS for any updates on the expected launch of streaming service Disney+ later this year, and especially for any insight from DIS executives on how DIS can build subscribership vs. heavy competition.

As of late last week, Q2 S&P 500 earnings were expected to rise 0.9%, according to research firm CFRA. That’s up from CFRA’s initial estimate in late June for a 1.5% earnings decline.

FIGURE 1:  MISERY LOVES COMPANY: Both the FAANGs (candlestick) and the semiconductors (purple line) were among the hardest hit parts of the market late last week as investors worried about building trade tensions with China. Data Sources: Nasdaq, Philadelphia Stock Exchange. Chart source: The thinkorswim® platform from TD Ameritrade. For illustrative purposes only. Past performance does not guarantee future results.  

Jobs Data Show Pay Up but Manufacturing Sector Softening: Friday’s jobs report for July was like a fastball down the middle without a lot of spin. It was right in the expected strike zone as far as meeting expectations, with little intrigue and no last-minute curves to fool anyone. Overall, it looked like a good report, coming in right as expected with jobs growth of 164,000, a little above the average Wall Street estimate of 160,000. Wages growth—a little better than expected at 3.2% year-over-year—also looked positive. If you’re the Fed and you’re looking for inflationary pressure, that’s a nice thing to see.

If you’re looking for something that’s less nice, it’s in the manufacturing sector. The rate of jobs created in manufacturing has slowed quite a bit from 2018. Some analysts say this could reflect the slowdown in manufacturing investment related to the trade battle with China, though there could be other reasons as well. One thing to think about going forward is whether this slowdown in manufacturing might eventually have an impact on jobs growth. The average factory work week fell in July, and if this trend continues, it’s conceivable that the next step could be layoffs at some companies.

Other Takeaways From Jobs: The retail sector saw job losses for the sixth month in a row in July, which is a bit ironic considering how strong consumer spending has been but might reflect more competition from online shopping vs. brick-and-mortar stores. Also, the Labor Department downwardly revised May and June jobs growth by 41,000 combined. So that really hot June jobs growth got clipped and now is less than 200,000. For the last three months, job gains have averaged just 140,000. That’s not a bad rate at all and more than enough to keep up with population growth, but it kind of pales compared to what we saw last year when growth averaged around 200,000.

Retail Earnings Just Around Corner: We’re still a couple weeks out from earnings season’s second wind, otherwise known as retail reporting season. It should be very interesting to hear from some of the big-box and department stores later this month considering the tariff issues and also recent signs of robust U.S. consumer health. One question out there is whether the Chinese trade situation could result in retailers dialing back their 2019 outlooks. Walmart’s (WMT) former CEO Bill Simon spoke on CNBC Friday and sounded relatively sanguine about the potential risk of new sanctions for that company.

Good Trading,

JJ 

@TDAJJKinahan 

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Economic calendar for week of Aug. 5. Source: Briefing.com

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Key Takeaways

  • Stocks begin the week under heavy pressure as trade war intensifies
  • Cautious tone prevails, with bonds, VIX, gold all rallying
  • Earnings season continues this week with Disney, Uber on calendar
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