Earnings and Tariffs are the two tails wagging the dog

Lawrence Kudlow, President Trump's head economic advisor, coined the phrase, “Corporate profits are the mother’s milk of the stock market."  Without profits, stocks will not go up in value.  Corporate profits for Q2 have been coming in better than expected and should be leading the market higher.

We believe current trade negations and the mid-term elections are currently weighing the market down. President Trump is pivoting away from trade spats with traditional US allies towards greater conflict with China. Trump believes that trade is helping him in the midterm elections and China thinks that Trump/Republicans will suffer losses in the midterms. The Chinese are trying to hold off negotiations until after the election because they think Trump will be weakened politically. As such, we do not expect a reprieve from China trade headwinds in the third quarter despite improvements in other trade areas.

The good news is that NAFTA negotiations have restarted and it's possible that there will be a NAFTA deal by Labor Day. The US and Mexico are near an agreement and once that is finalized (Aug 15 target), Canada will be brought in to complete the deal (Aug 26 target)

Last week President Trump negotiated a deal with the EU that avoids tariffs on EU autos for the time being and negotiations are underway to see if a larger deal can be reached on broader industrial tariffs. As part of the EU deal, Europe and the US agreed to reform the World Trade Organization (WTO). Although the deal did not specifically reference China, it is targeted at the country. The US wants to isolate China from the rest of the world to pressure them into reforms

Our sense is that the US and China will start negotiating after the midterm elections. This timetable could be accelerated if the Republicans improve in the polls as it would signal to the Chinese that Trump may in fact be emboldened after the election, not weakened. Conversely, if US economic growth were to slow meaningfully, it would force Trump to reevaluate his stance and the timing on these items. With Corporate profits hitting new highs and benefits from the tax plan still showing up in the data, we do not expect that economic growth to slow through the rest of 2018.

Capex spending is up year-over-year and is finally being rewarded by the market over share repurchases. Companies spending on capex are outpacing the S&P by nearly 200 basis points year-to-date. It is still early, but an emphasis on capital spending could greatly extend the business cycle as investments boost productivity, earnings and wages while keeping unit labor costs low and the Fed accommodative. 

Last week the indices edged higher despite volatility in response to trade tensions.  The Nasdaq Composite rebounded (0.96%) following two weeks of negative returns; the S&P 500? Index rose 0.76% followed by the Russell 2000? Index (+.62%) and the Dow Jones Industrial Average (+.05%.).  Strong earnings reports provided momentum; led by strong iPhone sales, Apple reported a higher-than-expected 8% increase in earnings.  The market’s positive response raised Apple’s market cap above $1 trillion, a stock market record.  The Technology sector benefitted not only from earnings reports but also company initiatives such as Qualcomm’s announced $10 billion share repurchase plan following its failed acquisition of NXP Semiconductors.  The market response to better-than-expected earnings reports has been somewhat mixed; investor concerns regarding trade tensions, the possibility that some companies are reaching peak revenue growth, and/or disappointing economic data may stall market momentum.

On Friday, the July jobs reports included a lower-than-expected number of jobs (157,000 versus 193,000); but the June number was adjusted higher (248,000 from 213,000) and the unemployment rate dropped to 3.9%.  Wages grew modestly to stay essentially even with inflation.  Employment conditions are the best since the Great Recession; many employers are initiating training programs to facilitate hiring of individuals without the experience or education usually required.  Trade tensions continue to dominate the headlines: the U.S. announced an increase, from 10% to 25%, of the potential trade tariffs for Chinese goods; China quickly responded with plans to place tariffs on an additional $60 billion on U.S. goods including oil and natural gas.  Furthermore, China indicated plans to continue purchasing Iranian oil after the re-imposition of the U.S. trade embargo in November.  To date, companies are reporting little trade-related impact on supplies or costs yet they are carefully monitoring updates.  This morning, the CEO of a major container leasing company indicated that shipping demand is strong; their clients expect little impact over the near term.

Trade, energy, Brexit and earnings reports dominate the news headlines; but, beyond the rhetoric, these issues have not disrupted the market’s advance.  The economy continues to provide market momentum.  The impasse between the U.S. and China is a potential threat; however, the markets continue to reflect expectations for a negotiated resolution.  So far, 80% of the companies in the S&P 500? have reported earnings.  Looking ahead, and absent a major event, the light trading volumes associated with late summer may expose the markets to some news-related volatility; otherwise, the markets will likely maintain their positive bias.

Source: Pacific Global Investment Management Copany

Chart reflects price changes, not total return. Because it does not include dividends or splits, it should not be used to benchmark performance of specific investments. 

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