U.S. equities have struggled to break out of a narrow trading range in recent weeks. Despite strong year-to-date returns, U.S. equities are only slightly above the level reached before last fall’s selloff.
The “stop-go” pattern of trading in recent weeks is an indication of investor uncertainty about several key issues. Slowing global growth, particularly in manufacturing, amplifies fears that the longest economic expansion in U.S. history is nearing an end. Bullish investors think that Chinese reflation, a pause in trade tensions and dovish central banks will be enough to keep the expansion going; bearish investors are skeptical about the likelihood of a trade deal and the willingness of the Federal Reserve to extend mid-cycle rate reductions into next year. Within equities, long-suffering value investors are hoping that the recent strength of value stocks represents a turning point in market leadership.
The fog of uncertainty may not clear anytime soon, given the likelihood that the coming months may offer only partial resolution of the major issues influencing equity markets:
1. A “grand bargain” between China and the U.S. is unlikely.
An economy in recession is not a recipe for re-election, which provides powerful motivation for President Donald Trump to de-escalate tensions with China before the 2020 vote. However, a temporary cease-fire or partial trade agreement is much more likely an outcome than the comprehensive deal that investors and corporate CEOs are hoping for. Frustration with China is seemingly one of the few issues in which Democratic and Republican voters are in agreement.
Trump runs the risk of being portrayed as being “soft on China” by Democratic opponents if he enters into a comprehensive deal with China. China’s president, Xi Jinping, faces his own set of constraints. Nationalist sentiment is high in China, and Xi is not likely to make concessions in the trade negotiations that alter its state-led economic model and the Communist Party’s control of the organs of the Chinese state.
2. Chinese economic stimulus is likely to fall short of investor expectations.
Chinese economic stimulus provided an important boost to global growth following the global financial crisis. Today China is prioritizing financial stabilization over reflation, with fiscal stimulus and easing of monetary policy relatively restrained in comparison to prior efforts.
Xi is concerned that another round of excessive debt creation would add to economic imbalances and hinder efforts to build a more sustainable economic model for China. Consequently, China’s leadership is willing to accept slower economic growth in order to slow the growth in leverage.
Trump’s trade policies and attacks on China provide a convenient scapegoat for a slowing economy, with nationalist sentiment keeping dissent in check on the mainland. Although Chinese stimulus should provide some spillover benefits to the rest of the world, the boost to global growth will probably far less meaningful than was the case in 2009 or 2016.
3. The Fed may also disappoint investors.
The Fed and European Central Bank are setting the tone in a world in which central banks implement expansionary monetary policies. However, the Fed may not provide as much monetary stimulus as is priced into the market today.