Handicapping the trade war has become a recent obsession on Wall Street, given the recent meltdown in talks and confusing rhetoric on both sides. The general theme that both sides have too much to lose is intact. Many believe that China is playing the infinite game and the US is playing the finite game, and the former always wins in traditional game theory. We mildly disagree with this premise given China’s debt overhang and profound reliance on the US as a key trading partner. We still think there is a better than 50/50 chance that this gets resolved in the next four weeks, culminating in a handshake agreement between Trump and Xi at the G7 summit in late June. The agreement may have less bite than preferred from the US negotiating team’s perspective, but with an election looming the risks of an extended trade war triggering a recession are too great. Compromise is in the air and kicking the can down the road on some critical structural changes in China may prevail.
Another trigger point, which seems completely benign at this point, is the Federal Reserve. In most cases the cause of a recession is the Fed overshooting on rate hikes, but that seems completely off the table now. Projections of a rate cut in Q1 2020 are now hovering around 60%, and this newly dovish Fed seems to be feeding renewed market risk appetite. Even the most recent selloff on the trade breakdown was backstopped by calm Fed rhetoric. “Goldilocks” is the buzz word making the rounds on the street, and the stock market wants to move higher.
On the flip side, the bond market seems to be telling a completely different story. A 10-year yield hovering around 2.4% and a very flat yield curve would indicate a slowdown and no China deal. This tug of war between stocks and bonds is nothing new and each has its own spotty track record, but lower yields also favor the case for increased risk appetite.
From a valuation perspective, international emerging and developed markets appear to be the best bet, but that story has been worn out over the last five years. The US markets are fairly valued based on historic PE multiplies, but it will be critical that we see some earnings growth in Q2 and Q3. Our current positioning is mostly sector-neutral, although we still lean toward technology with special emphasis on companies that will benefit from the rollout of 5G over the next five years. Healthcare will remain under pressure until the next election as single pay risk looms large, and we still support a market weight in financials due to valuation, even though many of the tailwinds from last year have disappeared.
Please let me know if you have any questions via email or phone at 804-774-2087, Jesse.Ellington@middleburgfinancial.com.
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