On Wednesday, U.S. stocks fell dramatically, with the Dow Jones Industrial Average falling more than 800 points. The rout was led by technology stocks, with the NASDAQ Composite Index down 316 points, but all sectors experienced losses.1 This was the worst one-day sell-off for U.S. stocks since February. For much of the day, bonds sold off as well but, by the end of the day, investors fled to the perceived safety of U.S. Treasuries, sending yields lower.
What drove the sell-off?
Stocks began losing ground last week as the yield on the 10-year U.S. Treasury spiked, helped by comments from U.S. Federal Reserve (Fed) Chair Jay Powell, who suggested that the Fed could raise rates significantly before finishing its rate hike cycle. Also placing downward pressure on Treasury prices has been balance sheet normalization as well as higher debt issuance as a result of the U.S. government running a larger deficit. As we have seen before, any significant increase in the 10-year yield typically results in a re-rating of stocks. Less than a month ago, the yield on the 10-year was 2.991% but since then it has risen rapidly, rising above 3.2% in the past week.1 Given that the tech sector has posted such strong returns in the past several years, it should not come as a surprise that it experienced a more severe re-rating than other sectors.
However, I also believe there is another reason for the sell-off: the growing trade wars. At times in the past year, protectionist threats and actions have sent stocks modestly downward, but investors have been all too willing to believe the threat has passed at the first sign of an abatement in trade drama. For example, after trade worries put downward pressure on stocks earlier this year, Chinese President Xi Jinping’s conciliatory speech at the Boao Forum in March was all investors needed to hear to send stocks upward. Realistically, this asymmetric reaction to trade developments – i.e., overreaction to positive trade news and underreaction to negative trade news – was not sustainable. In addition, negative consequences from the ongoing U.S.-China trade conflict had not yet appeared in the data, especially in the U.S. where the economy is accelerating, giving markets another reason to discount the threat. But that has started to change. This week, the International Monetary Fund (IMF) downwardly revised its estimates for global growth, as well as growth for China and the U.S., as a result of the escalation in trade tensions:
The IMF projects that long-term gross domestic product (GDP) for the U.S. and China will each decline 0.3% as a result of all the tariffs implemented as of September 2018.2
It expects long-term U.S. GDP to decline 0.5% and long-term China GDP to decline 0.55% if the U.S. imposes its threatened 25% tariff on an additional $267 billion in Chinese goods, and China retaliates.2
In addition, it expects long-term U.S. GDP to decline 0.9% and long-term China GDP to decline 0.6% if the U.S. imposes its threatened 25% tariffs on cars and parts, and then trading partners retaliate.2
The IMF of course expects this to have a negative impact worldwide, with long-term global GDP projected to decline 0.4% if all tariffs discussed above are implemented.2
The IMF expects the impact of the current trade conflict to be felt in 2019: its estimate for U.S. GDP growth was downwardly revised to 2.5% from 2.7%, while China GDP growth was downwardly revised from 6.4% to 6.2%.2
In addition, companies are beginning to report that tariffs are impacting their businesses. On Wednesday, U.S.-based industrial supply company Fastenal reporting earnings and discussed the headwinds being created by the trade conflict, in particular sharing that the most recent tariffs are “directly impacting the North American supply chain for our customers.” This disruption of global supply chains has been a major concern for economists and strategists. As the Cato Institute explained in a commentary earlier this year3, “Whereas in the 20th century, most of a company’s production and assembly took place in one location, often under one roof, the factory floor has since broken through those walls and now spans borders and oceans. Taxing imports today is akin to erecting a wall through the center of that 20th century assembly line, impeding production and raising costs in similar fashion. That helps explain the preponderance of opposition among U.S. manufacturers to Trump’s trade tack. U.S. tariffs raise their costs, and the resulting retaliation from foreign governments will reduce their export revenues, squeezing profits from both ends.”
What are the potential investment implications?
There are concerns afoot that this could be the start of a market correction, and it may very well be. I have warned about the likelihood of a sell-off in the back half of the year that resembles the February sell-off – meaning a sharp but relatively swift sell-off and then the potential for a recovery.
In a survey we at Invesco conducted both before and after the February sell-off, we found that investor confidence in stocks diminished after the sell-off – in the first quarter, 80% of investors felt it was a good time to invest, but that declined to 69% in the second quarter. Moreover, before the sell-off, 65% of investors believed we were in a bull market, compared with just 37% after the sell-off in April. To me, this suggests investors may flee stocks at the first sign of trouble.
And so I believe there will be some contagion in the near term – indeed, Asian stocks are already down.1 I expect a significant sell-off that extends internationally, although I expect the U.S. will feel the most pain. Having said that, earnings season is likely to be strong, in my view, which would provide some support for stocks and may help them rebound relatively quickly.
What is our outlook on the situation?
I have been warning for more than a year that the two key risks to the economy and markets are normalization by the U.S. Federal Reserve and protectionism. It seems that these forces are both at play, creating something of a “perfect storm” that is causing market disruption. Having said that, I believe that longer-term investors, especially institutional investors, who need capital appreciation potential in order to achieve investment goals should consider maintaining exposure to risk assets, but with an emphasis on downside protection. Therefore, this could create an opportunity for active management, especially in certain asset classes.
I have also been warning that these risks underscore the importance of broad diversification – that may mean diversification within equities (by region and factor) and fixed income (by sub-asset class) but also adequate exposure to alternative asset classes, which have historically exhibited lower correlations to equities. Unless an investor has a short time horizon, I believe it is important to consider a broadly diversified investment portfolio that includes risk assets. In addition, tactical investors can take advantage of buying opportunities created by the sell-off.
What are we watching out for?
We will want to follow the trade situation closely. If it deteriorates significantly, a reduced exposure to risk assets may be warranted.