Everybody wants to maintain their bullish outlook on U.S. stocks because after all, being bearish on U.S. equities hasn’t exactly paid off this year.
Thanks in no small part (and arguably thanks entirely) to the tax cuts boosting corporate bottom lines and catalyzing a buyback binge, U.S. benchmarks have managed to shake off all manner of ostensibly bearish news and developments including, but by no means limited to, i) the largest one-day VIX spike in history and a subsequent forced unwind from systematic strats, ii) regulatory jitters in tech, iii) trade wars, iv) a brutal unwind in the BTP market, v) the collapse of the Turkish lira, vi) bear markets in EM equities, European financials, European autos, Chinese stocks and copper.
Through it all, U.S. stocks managed to push to new highs late last month, prompting some on the sellside to push up their year-end SPX targets…
(SPX versus Wall Street consensus / Bloomberg)
… and leaving the buy-side in the dust.
(Hedge funds fall behind and are forced to “grab” for exposure in August / Bloomberg)
You can understand why folks are reluctant to turn bearish. Still, the risks are myriad and even if you can get past the ongoing tumult in EM and the specter of more quantitative tightening as the Fed’s balance sheet rundown continues, the ECB tapers to €15 billion/month on the way to zero by year-end, and the BoJ’s halting efforts to start down the (long) path to normalization, you’re still left to ponder the U.S midterms and the possibility of more escalations in the trade wars.
As far as the midterms are concerned, it’s entirely possible that the House flips to Democrats, triggering a series of investigations that stymies Trump’s policy platform and leads to outright gridlock in D.C. As far as BofAML is concerned, that’s not the worst thing in the world for equities, but as we never tire of reminding you, these are unprecedented times for U.S. politics and there’s really no telling what’s going to happen on the legal front for the President going forward.
On the trade front, the Trump administration is widely expected to move forward with tariffs on an additional $200 billion in Chinese goods. That would prompt an immediate response from Beijing in the form of differentiated duties on $60 billion in U.S. products. As a reminder, there is no way for the administration to avoid a scenario where consumer prices rise in the next round and the more upward pressure the protectionist push puts on domestic prices, the more prone to hawkishness the Fed will be.
The question mark around the next escalation between Washington and Beijing relates to whether Trump will opt for a 25% duty or a 10% levy. There’s a ton more on that here, but the bottom line is that the higher the tariff rate, the more upside risk for inflation and the more downside for risk assets.
Well, in light of the above, UBS is out with a new piece that finds the bank walking the fine line between acknowledging the possibility of more upside for the S&P while being mindful of the geopolitical risks.
The bank begins by laying out the “5 pillars to a positive U.S. equity view”. They are, in order (and this is truncated for brevity and also out of respect for the original, which is more than 20 pages long and contains a lengthy exposition on all points):
1. Consumer spending has further to run with the savings rate still 50bp above pre-tax boost levels and confidence so high.
2. Investment spending accelerated in Q2 with ~25% profit growth pointing to big growth next year too.
3. Margins are rising on strong sales with better pricing more than offsetting rising wages.
4. Corporate flow is tracking ~$2.4tr (~10%+ of cap), between dividends, buybacks and M&A and less than ¼ of repatriatable profits have been tapped.
5. Valuation drivers have been supportive as rates settled down and growth expectations rose, but the P/E is below fair.
So that’s the good news. The bad news is, again, the prospect of an escalation in the trade conflict which UBS doesn’t believe is completely priced in. The bank is on the same page with (almost) everyone else in that they expect the Trump administration to move ahead with tariffs on an additional $200 billion in Chinese goods by the end of this month. Their base case is for the tariff rate to be 10%.
“In our view, recent talks with the EU and Mexico help mitigate the downside scenario of the US fighting a trade war on two fronts, at least near-term, [but] the prospect of 25% tariffs on the $200bn of China imports is not fully priced”, UBS warns, before going on to predict that earnings would likely suffer a ~3% hit under the base case scenario with U.S. stocks falling some 2% (UBS thinks a bit of this is already priced in).
As far as what happens in the event the USTR goes ahead and applies a 25% tariff in the next round of 301 investigation-related duties, things would be materially worse.
“A 25% tariff rate could be construed as an escalation and would have a greater earnings impact and markets would need to price the potential for continuing escalation, thus, 25% tariffs could lead to a 5%+ type pullback”, UBS cautions.
One of the problems with the 25% escalation scenario is that it isn’t clear how Beijing would respond. We know we’re going to get the differentiated tariffs on $60 billion in U.S. goods, but they could take other steps if Trump is seen as pushing the envelope too far (as if he hasn’t done that already). Having taken a series of steps to arrest the slide in the yuan last month (and thus indicated that further currency depreciation is not desirable), China would likely have to resort to “alternative” measures. The ambiguity around what that would entail is a source of consternation for investors and traders.
Finally, UBS notes that there is one way out of this and you can probably guess what it is…
However, the Fed skipping a hike in Dec, our economists view, could provide an important offset for trade risks, particularly since the USD has been a key driver of relative equity returns.