Stock Market’s Crystal Ball Reveals Inconvenient Truth

(Bloomberg Opinion) -- Financial markets tend to be forward-looking. As such, it matters little to investors that U.S. economic growth this quarter is tracking at a greater-than-4 percent annualized rate by some measures. What they really care about is what's ahead, and it's growing evident that investors don't like what they see.

The S&P 500 Index fell for a third straight day on Tuesday, dropping as much as 1.1 percent, as growing trade tensions between the U.S. and China only served to underscore the fact that Wall Street strategists are pricing in a much slower pace of earnings growth in coming quarters. Although estimates compiled by Bloomberg show equity analysts see profits for members of the S&P 500 rising 24 percent this year, much of that growth was front-loaded in the first and second quarters. For 2019, earnings growth is seen decelerating to a 10 percent pace. That's still impressive, of course, but not impressive enough to justify stock prices that are a lofty 21 times earnings on average. It won't be long before investors begin to ask themselves whether it makes sense to keep paying above-average prices if growth isn't accelerating.

To be sure, the S&P 500 is still up 4.61 percent this quarter, and many economists say that a $200 billion trade dispute is small potatoes when it comes to the size of the U.S. economy. Nevertheless, what investors are concerned about is an escalation of trade tensions. "There is a point at which the numbers start to have a more meaningful influence and more importantly, we find ourselves worried about the fallout for business confidence," the strategists at BMO Capital Markets wrote in a research note Tuesday. "Even within the Fed’s most recent Beige Book, there were concerns raised by business leaders regarding the implications for future investment resulting from the uncertainty associated with renegotiating America’s primary trade relationships."

WATCH THE YUAN
There is a line of thinking that says the U.S. has the upper hand over China in a trade war. After all, China only imports $135 billion to $150 billion of goods from the U.S., depending on how you measure it, so there's a limit to the levies China can place on U.S. stuff. Also, it's unlikely that China would dump its $1.18 trillion of U.S. Treasuries, as it would only be hurting itself as bond prices collapsed. But there is a third option, and it may already be in play. That would be letting its tightly controlled currency, the yuan, depreciate, thereby making its exports more competitive. The yuan declined 0.72 percent Tuesday after falling 0.58 percent Friday (Chinese markets were closed for a holiday Monday). That was the biggest two-day slide since August 2015. If China decides to "weaponize" the yuan and use it as a tool to fight back against the U.S. tariffs, it would be a very risky strategy. "A devaluation of sufficient magnitude to blunt the tariff would likely open the proverbial Pandora's Box and spur the vicious cycle of outflows and depreciation and set back China's other strategic goals," Marc Chandler, the head of currency strategy at Brown Brothers Harriman & Co, wrote in a research note Tuesday. Regardless, the market is expecting more declines in the yuan. At 6.4853 per dollar, the yuan is the weakest since mid-January. The yuan is also trading at about the biggest discount to the central bank’s daily fixing rate since February, reflecting bearish sentiment, according to Bloomberg News's Tian Chen. 

UNPRECIOUS METAL
Given all the anxiety in global markets at the moment — with the U.S.-China trade spat, the big selloff in emerging markets and the slowdown in Europe's economy — one might expect this would be gold's time to shine. Instead, the precious metal closed at a fresh low for the year of $1,277.60 an ounce on Tuesday, extending its decline from this year's high of $1,379 on Jan. 25. Bullion has been under pressure as a hawkish Federal Reserve raises the prospect for higher interest rates. That dims the relative appeal of gold, which doesn’t pay interest. "We have been cautious about gold just because we still see a stronger dollar and the Fed raising rates as headwinds,” Rob Haworth, a Seattle-based senior investment strategist at U.S. Bank Wealth Management, which oversees $154 billion, told Bloomberg News. Some of gold’s most loyal investors have exchange-traded funds, but there are signs that even they are starting to lose faith, according to Bloomberg News's Luzi Ann Javier. Holdings in iShares Gold Trust, the second-largest bullion-backed ETF, shrank by about half a million ounces in the past five weeks. That marks a reversal in sentiment seen just a month ago, when assets in the fund climbed to a record, even as the price of gold fell.

SYSTEMIC MARKET RISK?
The seemingly counterintuitive performance of gold of late speaks to a bigger trend in financial markets at the moment, which is that little seems to be making much sense. A Morgan Stanley index that tracks correlation among regions and asset classes has reached its highest level since December 2016, a possible signal that the market’s defensive positioning could prove more lasting, according to Bloomberg News's Yakob Peterseil and Dani Burger. “The fact that this index is trending higher currently could well be the true signal for market players to realize that current multi-asset moves toward risk aversion may be more than short-term,” Tim Emmott, executive director at Olivetree Financial, wrote in a research note. Flights to safety this year have occurred in short bursts without much of a domino effect across asset classes. The CBOE Options Exchange Volatility Index, or VIX, still sits at its five-year average, while Treasury and currency volatility measures are far below their norms, Peterseil and Burger report. Of course, that may change as anxiety levels increase. Emmott points to discussions about central bank monetary policy errors that have emerged in the wake of the latest Fed meeting, the continued difficulty the ECB faces in raising rates and negative data out of China as rendering “the global inflation trade questionable at least.”

BAD TIMING
The trade tensions may be having the most impact in commodities markets. The sell-off in raw materials deepened Tuesday, with the Bloomberg Commodity Index falling as much as 2.08 percent before paring those declines to end down 1.20 percent for the day. Agricultural products have been particularly hard hit, with China saying last week it would follow through on plans to levy tariffs against a slew of American farm goods. November soybean futures sank as much as 7.2 percent to $8.645 a bushel, the lowest price for a most-active contract since March 2016. Soybeans are the top U.S. agricultural export to China. Wheat and cotton futures also posted steep losses, while corn, soy meal and bean oil also declined, according to Bloomberg News' Megan Durisin and Shruti Date Singh. The timing couldn't be worse, as the trade dispute comes in the midst of the U.S. growing season. “If the tariffs continue, it will stop our exports and start to build our supplies,” Virginia McGathey, president of McGathey Commodities Corp., told Bloomberg News. “That’s an anchor on the prices.” Adding to the bearish sentiment are current weather conditions, which continue to be favorable for U.S. crops. In weekly ratings issued on Monday, the U.S. Department of Agriculture said 78 percent of corn is in good or excellent shape. The amount of spring wheat in top condition also surged.

TEA LEAVES
Fans of central banking — yes, there are some out there — must be in heaven. The world's top central bankers are in Sintra, Portugal, this week for the European Central Bank's annual policy forum. The big event comes Wednesday, when Fed Chairman Jerome Powell, ECB President Mario Draghi, Bank of Japan Governor Haruhiko Kuroda and Reserve Bank of Australia Governor Philip Lowe take part in a panel to discuss policy. The discussion comes at a time when the global synchronized economic recovery that was all the rage last year seems to have fizzled, with just the U.S. showing any real strength. Markets could move depending on what the panelists say about the potential fallout from the budding trade war between the U.S. and the rest of the world, as well as the recent sell-off in emerging markets.

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To contact the editor responsible for this story: Beth Williams at bewilliams@bloomberg.net

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