Progress with China drives stocks higher Progress with China drives stocks higher http://www.federatedinvestors.com/static/images/fed-logo-amp.png http://www.federatedinvestors.com/daf\images\insights\article\china-us-flags-small.jpg October 28 2019 October 11 2019

Progress with China drives stocks higher

If a trade deal emerges, leading to expectations for GDP and corporate-profit growth, look for a year-end rally.
Published October 11 2019
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Bottom line Perhaps it was the lucky thirteenth round of bilateral trade negotiations between the U.S. and China in Washington, D.C., this week that did the trick. After a powerful 29% rally from its Christmas Eve trough to its late July record high of 3,028, the S&P 500 had corrected by about 6% into early October. Investors were increasingly worried the escalating trade and tariff war between the world’s two largest economies, which has been dragging on for 18 months, was beginning to hurt economic growth. Last week, in fact, the September readings for the ISM manufacturing and service indexes hit fresh 10-year and 3-year lows at 47.8 and 52.6, respectively, with investors pointing to China as the culprit.

As we’ve looked across the proverbial valley regarding China, we’ve had two dates circled on our calendar: Oct. 10 and Nov. 17. Starting yesterday in Washington, Treasury Secretary Mnuchin and trade representative Robert Lighthizer met with Chinese Vice Premier Liu He to resurrect the trade talks derailed in May. If these discussions were fruitful, then President Trump and China’s President Xi, who are both scheduled to attend the Asia Pacific Economic Cooperation (APEC) Summit on Nov. 16-17 in Santiago, Chile, where they are expected to meet privately, might tweak and bless the work.

In our view, because both countries desperately want— and need—a trade deal, we’ve envisioned three escalating positive outcomes from these discussions:

  • Do no harm Don’t escalate the existing tariffs, and end the incendiary rhetoric.
  • Skinny deal Modest progress on trade, by which we lower tariffs in exchange for increased exports of agricultural products (soy beans and pork) and natural gas.
  • Comprehensive structural reforms Successfully address the thornier issues at the heart of this dispute, including the theft of U.S. intellectual property, forced technology transfers from U.S. companies to Chinese one and Chinese currency manipulation.

We continue to believe that a mutually agreeable resolution can be reached between the U.S. and China over time. But over the last three days, stocks have soared nearly 4%, with benchmark 10-year Treasury yields rising from 1.50% to 1.75%. Bearish investors now have begun to adopt a more constructive view on a partial agreement and a trade truce, with a potentially comprehensive deal in the future (perhaps as early as next month).

From Tuesday’s close at 2,893, the S&P 500 was trading at only 16 times our estimate for 2020 of $180, and we continue to believe there is no recession on the horizon this year or next. With core PCE inflation at 1.8% year-over-year in August, and with at least one or two more Federal Reserve rate cuts in the monetary-policy pipeline this year, we believe stocks remain cheap. At our conservative target P/E range of 18-18.5 times, we are sticking to our 3,100 target for year-end 2019, 3,300 for mid-2020 and 3,500 for year-end 2020.

All China, all the time? While progress on trade talks with the so-called 800-pound panda has certainly captured the attention of the financial markets in recent days, there are several other key developments here and abroad before the APEC summit on Nov. 17 that could be potentially market moving:

  • FOMC meeting Oct. 30 We expect the Fed to cut interest rates by a quarter point, orchestrate some organic expansion in its balance sheet and provide some guidance regarding their Dec. 11 policy-setting meeting.
  • Brexit deadline Oct. 31 Tentative progress finally is being made ahead of an Oct. 17-18 summit, with guarded optimism that Prime Minister Boris Johnson can avoid the dreaded no-deal Brexit.
  • ECB transition Oct. 31 Mario Draghi’s successful 8-year term as head of the European Central Bank ends, with a transition to Christine Lagarde, currently the chair of the International Monetary Fund. But Lagarde, like current Fed Chair Jay Powell, lacks a Ph.D. in economics, so it’s unknown how smooth the transition will be.
  • ISM updates Nov. 1 and 5 Will October’s manufacturing data released Nov. 1 and the services data on Nov. 5 show any improvement from September’s multi-year troughs?
  • Labor market Nov. 1 Will October’s nonfarm payrolls report released Nov. 1 strengthen from tepid levels last month? Or will the ongoing strike between General Motors and the United Auto Workers, which has sidelined 46,000 workers, negatively impact the report?

Conclusion We lightened our 8% equity overweight to 3% this past summer, because we feared that increased volatility during the August-October period for the host of aforementioned reasons might reduce stock prices by some 5-8%. October is the month that bear markets typically go to die, and with stocks down nearly 7% from their July peak, investors appear to have already discounted the bottom in recent days. With the prospect of stronger GDP and corporate profit growth next year due to a trade deal with China, investors are now beginning to price in a powerful year-end rally, which we believe should continue into 2020.

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Tags Equity . Markets/Economy . Politics .
DISCLOSURES

Views are as of the date above and are subject to change based on market conditions and other factors. These views should not be construed as a recommendation for any specific security or sector.

Gross Domestic Product (GDP) is a broad measure of the economy that measures the retail value of goods and services produced in a country.

The Institute of Supply Management (ISM) manufacturing index is a composite, forward-looking index derived from a monthly survey of U.S. businesses.

The Institute of Supply Management (ISM) nonmanufacturing index is a composite, forward-looking index derived from a monthly survey of U.S. businesses.

Price-Earnings Ratio is a valuation ratio of a company's current share price compared to its per-share earnings.

Personal Consumption Expenditure (PCE) Index: A measure of inflation at the consumer level.

S&P 500 Index: An unmanaged capitalization-weighted index of 500 stocks designated to measure performance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing all major industries. Indexes are unmanaged and investments cannot be made in an index.

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