Sunday, October 13, 2019

A China Trade Deal: Reset Higher In Market And Economic Expectations

The equity market ended this past week on an upbeat note, reacting positively to a China/U.S. trade deal. In looking at the Dow Jones Industrial Average Index, it gapped higher by 197 points at the open on Friday and was up as much as 517 points until late in the day. The below chart shows the S&P 500 Index and a similar gap higher open occurred Friday.

This year the S&P 500 Index is up 18.49% on a price only basis and up 20.38% including dividends. A large portion of this year's return came in the first quarter and was a bounce back from the fourth quarter decline in 2018.

Jeff Miller, Ph.D., who writes at Dash of Insight, noted in his weekly post that the trade deal may be "a defining moment for the financial markets." His post highlights positives that may result from the agreement such as an improvement in economic growth, extension of the business cycle and more. One important viewpoint is the need to reset one's conclusions derived from some recent analysis, such as, forget the recession risk predicted by the inverted yield curve, or the slowdown in the past earnings growth rate is less important than projected earnings growth resulting from a faster global economic growth rate. Those investors that reduced equity exposure in anticipation of a recession due to the inverted yield curve are likely in need of working investment dollars back into stocks. As the below chart shows, money market fund assets have been on an extended climb since tariffs were announced in early 2018. Money market assets now stand at nearly $3.4 trillion as of the end of August.

Looking at fund and ETF flows in domestic and foreign stocks along with bonds, clearly investors have reduced equity exposure by more than $1 trillion since the tariff announcement. The beneficiary of investors' excess cash has been bonds (green shading below) and money market funds.

Both the 3-month and 2-year Treasury yields are now lower than the 10-year yield. In other words the yield curve is steepening and is no longer inverted. A further steepening of the curve, and likely a shift higher in rates on the longer end of the curve, would be a headwind for bond investors. With a China trade deal now a reality, a reset higher in positive expectations would be favorable for the economy and investment markets.

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