Global markets sold off sharply this morning on the heels of escalating trade rhetoric from President Donald Trump over the weekend. Previously, markets had a sense that a trade deal with China was close. Now it’s unclear given the threat of new tariffs against China.

 

Does this change the near term or even year-end forecast for equities? The answer is no. While the US/China deal timeline is now in doubt, equity prices ultimately “look through” near term uncertainty. Hence, the key issue is the shorter term tactical impact on stocks.

 

Stocks are near all-time highs and enjoyed a relentless rally since the start of the year. The natural question by investors is whether this setback is enough to trigger a 5%-10% pullback. While renewed US/China trade tensions may seem like a supportive argument, a pullback of this magnitude would need to be predicated on an escalation of tensions — one where China threatens further retaliation, thus triggering another painful cycle of falling confidence, inventory correction and downturn in PMIs. Given that US has demonstrated relatively strong economic resilience while China has demonstrably weakened, it doesn’t appear that China has a strong hand to play in that regard.

 

Additionally, there is just too much dry powder (i.e. cash) on the sidelines. Retail investors have been selling stocks and buying bonds in 2019. Hedge fund net long positions are among the lowest levels in 5 years. Hence, only the long only funds are fully exposed to equities. With so much cash on the sidelines, a stock market near its highs, and fund manager underperformance, I see this dry powder (i.e. cash) as a key dynamic.

 

The Fed is also likely to be more market friendly in the event of escalating tensions. Unlike 2018, where the Fed seemed blinded by data dependency, I believe any mounting financial stress will be met by an eventual Fed response.

 

Bottom line: Any pullback should be shallow, even as risks of China escalation are probably forthcoming. Buy the dips.

 

Tim