How the trade war is affecting markets, and what to do about it

It feels a bit like watching a soap opera …

Yesterday began on a dark note — China “broke the deal.”

The comment from President Trump pulled down the Dow over 400-points in the morning. The early rhetoric was that even though Liu He, China’s vice premier and top trade negotiator, would be arriving in Washington by the evening, a trade agreement was unlikely to be reached.

That would mean that as of 12:00 this morning, new tariffs, raised to 25%, would be placed on some $200 billion in Chinese goods.

But as the day progressed, there was hope — President Trump set an optimistic tone, saying that Chinese President Xi Jinping had written him a “beautiful letter” and that Xi had expressed a desire to come to an agreement.

Markets rallied on the news, the Dow ending down just 140 points rather than the 400+ from earlier in the day.

Unfortunately, despite the hope of a last-minute deal, no resolution was reached. As I write Friday morning, the Dow is down nearly 300 points after President Trump slapped China with the tariff increase.

***How did this blow up? How did we get here?

After all, just days ago, it appeared U.S. and Chinese delegates were on the verge of reaching an agreement. Let’s do a brief recap …

According to Reuters, it began last Friday night, when Washington received a diplomatic cable from Beijing, containing systematic edits to a 150-page draft trade agreement. Allegedly, the document was filled with reversals to previously agreed-upon deal-points that undermined core U.S. demands.

Specifically, China had deleted its commitments to change laws surrounding theft of U.S. intellectual property and trade secrets, forced technology transfer, and currency manipulation.

Behind China’s sudden reversal was the belief that the U.S. was caving. According to The Wall Street Journal, Beijing interpreted recent statements and actions from President Trump as indicating he was ready to make concessions. China smelled blood in the water and tried to take advantage.

Reuters reports that a private-sector source familiar with the negotiations said “China got greedy … The talks were so bad that the real surprise is that it took Trump until Sunday to blow up … After 20 years of having their way with the U.S., China still appears to be miscalculating with this administration.”

Unfortunately, it’s a miscalculation that appears to have derailed months of progress.

At a rally on Wednesday, President Trump said “By the way, you see the tariffs we’re doing? … Because they broke the deal. They broke the deal. So they’re flying in, the vice premier tomorrow’s flying in — good man — but they broke the deal. They can’t do that, so they’ll be paying.”

China’s response?

The commerce Ministry Spokesman Gao Fend told reporters “China is credible and honors its word and that has never changed.”

Regardless of who did what, the end result is the same — new tariffs are in effect, and the U.S. and China appear far from an agreement.

***While new tariffs would be enacted with the intent of hurting China, it will actually be the U.S. consumer that feels the pain

To explain why, let’s turn to John Jagerson and Wade Hansen, editors behind Strategic Trader. John and Wade are two of the best market tacticians in the business.

From Wednesday’s Strategic Trader update:

… tariffs are a tricky issue. Despite what the President’s tweets said, Chinese companies do not pay tariffs to the U.S. government. U.S. importers are responsible for paying tariffs, and those costs are usually passed on to consumers. It’s reasonable to be confused about that issue because other market factors have hidden many of those costs.

This echoes what we reported in our 

Tuesday Digest, when we referenced a study that suggested Trump’s new tariffs in apparel imports would raise costs for a family of four by roughly $500 a year.

John and Wade go on to explain that the effects of the tariffs (from the U.S. consumer’s perspective) have been watered-down thanks to a strong U.S. Dollar.

Back to John and Wade:

A stronger dollar has more purchasing power for foreign goods, including Chinese products. Although imported Chinese goods are more expensive for importers and consumers due to tariffs, many of those costs have been hidden by the dollar’s strength …

We feel that most of the negative consequences of the tariffs are still long-term issues and could be mitigated by a successful deal between the U.S. and Chinese trade negotiators. However, trade will continue to be an important X-factor that will create volatility in the market.

***On the topic of volatility, let’s not miss some warning signals from the market, starting with the VIX

The VIX, sometimes called the “fear index” measures traders’ expectations for volatility over the ensuing 30 days. When it’s high, it means traders are nervous, expecting lots of volatility. A level of “20” is often considered the line in the sand, separating calmer markets from more nervous markets.

Yesterday, the VIX hit a fresh high of 23.38, its highest level since January 4. It did pull back after Trump tried to set an optimistic tone regarding negotiations. But the new, recent high is certainly worth noting.

***Next, small-cap stocks fell back into correction territory yesterday

That means they’re down 10% from highs. The reason this is significant is because many analysts consider the performance of small-cap stocks, as measured by the Russell 2000, to be a leading indicator. In other words, what the Russell 2000 does is considered by some to be a preview of what’s to come in the broader market.

You see, many of these small-cap companies hold more debt than their large-cap counterparts. This makes them more sensitive to various economic factors — so, they’re a bit like the canary in the coal mine.

Of course, it’s important to keep a balanced perspective on the Russell 2000. Prior to this week’s decline, small caps were having their best start to the year since 1987. As I write, the index is down 3.8% on the week, compared to the S&P 500’s 3.5% decline.

***Then, we have a yield curve warning from the bond market

Yesterday, we saw a new yield curve inversion. Specifically, the yield on the 10-year Treasury note fell below that of the 3-month bill. While an inversion has been a somewhat reliable recession indicator in the past, that doesn’t mean a recession — or even a major stock market pullback — is going to happen tomorrow.

Stepping back, rather than look at any one of these indicators in isolation, it’s more effective to consider them all together, a collage, of sorts.

***So, how might a trader interpret this collage of signals?

For that, let’s turn back to John and Wade:

From a technical perspective, experiencing some volatility in the S&P 500 while it is at long-term resistance isn’t unexpected. It might even create some good bullish opportunities on stocks that dip to support, as long as the tariff war doesn’t escalate further …

… we feel most of the issues the market is dealing with are short-term in nature …

However, because there is still significant uncertainty this week about the fate of the current tariffs, we plan to trade very lightly until some of the unknowns are resolved.

So, caution for the moment as we wait for an all-clear signal from the trade negotiations.

We’ll continue to monitor developments out of Washington and keep you informed here in the Digest. In the meantime, if you’d like more analysis from John and Wade, click here.

Have a good evening,

Jeff Remsburg