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Healthy Pullback in U.S. Equities While Trade Deal Uncertainty Looms

If you have gains after this recent rally that have resulted in the equity portion of your stock portfolio moving out of your long-term strategic comfort zone, taking profits may be prudent.

Stocks rebounded from the “near bear market” low in late December, but stalled as new records were set; before pulling back as trade tensions with China ratcheted up. We wouldn’t mind seeing the pullback pick up a bit of steam in the interest of bringing in both sentiment and valuations, which had gotten stretched recently. We have no special or unique insight into the trade discussions, and there is a chance that the dispute could escalate and be a bigger drag on both stocks and the economy—bolstering further the case for diversification across and within asset classes.

Sentiment had moved further into the extreme optimistic territory according to the Ned Davis Research Crowd Sentiment Poll, typically a contrarian indicator at extremes.

Sentiment still overly optimistic

Additionally, there may be additional selling pressure as we enter a historically weaker time of the year—promoted by the “sell in May” adage. We can’t deny that there is much truth in that saying, but we would never promote an all-or-nothing trading strategy based on the calendar.

As mentioned, investor sentiment has gotten extended, but it doesn’t appear that investors are rushing to put money into stocks, which would raise the threat of a “melt-up.”

Where does that leave us? We believe a larger pullback would help ease both sentiment and valuation excesses. But we also believe we are late in the economic cycle and that recession risk is rising. If last year’s near-bear market was not a warning sign of a near-term recession, U.S. stocks are likely to resume their rally. However, if the yield curve were to invert again, a trade deal to fall apart and/or economic data were to continue to disappoint, a recession might begin sooner than the consensus believes; which would be a risk for stocks. For now, we remain “neutral” on U.S. equities, which means we are recommending investors remain at their long-term strategic allocation to stocks, without letting rallies get investors “over their skis.”

Productivity may be perking up

So everything’s rosy, right? Unfortunately, we are starting to see some cracks under the surface of the economy. Initial unemployment claims is a key leading economic indicator, and they’ve been ticking up over the past few weeks; while the Institute of Supply Management’s (ISM) Manufacturing and Non-Manufacturing Indexes were both weaker than expected in April; with notable weakness in manufacturing new orders.

One factor underpinning the rally that began late last year was the complete turnaround by the Fed from a rate hike in December 2018 to a pause since January 2019. In fact, the fed funds futures market currently has priced in the next move being a rate cut. That pendulum may have swung a bit too far too fast, with the recent Fed statement and subsequent press conference emphasizing that “the Committee will be patient” in its determination of a potential next move—indicating to us it could go either way. We will continue to listen to Fed members’ reactions to incoming data and speeches for hints as to its bias looking forward.

Bad time for trade deal delay

The market’s focus shifted as stock markets around the world pivoted from a view that a deal between the United States and China was imminent to concerns about the deal falling apart. Yet, there is more risk to investors for a deal falling through now than there was a few months ago. First quarter economic growth in both the United States and China exceeded expectations and may have emboldened both sides to hold out on key concessions.

While a delay is possible, accompanied by a tariff increase from 10% to 25% on $200 billion of Chinese goods, it is still possible that talks will resume and a trade agreement is ready for a signing ceremony at the G20 summit in Japan on June 28.

A failure or lengthy delay to a trade deal would come at a bad time for the global economy. Global manufacturing activity is in the longest slump in the more than 20-year history of the global purchasing managers’ index (PMI).

With global stocks vulnerable to a pullback, it is fortunate for investors that the trend in the degree to which the world’s stock markets move in sync with each other has been trending lower.

So what?

Some volatility has returned and we believe a pullback in U.S. equities is a healthy development in terms of both investor sentiment and valuations. But some cracks in economic growth may be emerging, and inflation could start to rise given the tight labor market, so investors should remain disciplined with an eye toward rebalancing in the face of volatility. Trade remains a weight on the confidence of business leaders, and if the dispute with China continues to escalate, stocks and the economy would likely suffer further.


Important Disclosures

Investment involves risk. Past performance is no indication of future results, and values fluctuate. International investments are subject to additional risks such as currency fluctuations, political instability and the potential for illiquid markets. Investing in emerging markets can accentuate these risks.

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market conditions. Data contained herein from third-party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Diversification and rebalancing a portfolio cannot assure a profit or protect against a loss in any given market environment. Rebalancing may cause investors to incur transaction costs and, when rebalancing a non-retirement account, taxable events may be created that may affect your tax liability.

Past performance is no guarantee of future results. Forecasts contained herein are for illustrative purposes only, may be based upon proprietary research and are developed through analysis of historical public data.

Ned Davis Research (NDR) Crowd Sentiment Poll ® shows perspective designed to highlight short- to intermediate-term swings in investor psychology.

The Institute for Supply Management (ISM) Manufacturing Index is an index based on surveys of more than 300 manufacturing firms by the Institute of Supply Management. The ISM Manufacturing Index monitors employment, production inventories, new orders and supplier deliveries.

The Institute for Supply Management (ISM) Non-manufacturing Index is an index based on surveys of more than 400 non-manufacturing firms by the Institute of Supply Management. The ISM Non-manufacturing Index monitors employment, production inventories, new orders and supplier deliveries.

'Purchasing Managers Index - global PMI' is an indicator of the economic health of the manufacturing sector. The PMI index is based on five major indicators: new orders, inventory levels, production, supplier deliveries and the employment environment.

Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.

The Schwab Center for Financial Research is a division of Charles Schwab & Co., Inc.

About the author:
Liz Ann Sonder, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
Jeffrey Kleintop, Senior Vice President and Chief Global Investment Strategist
Brad Sorensen, CFA, Director of Market and Sector Analysis, Schwab Center for Financial Research

Content provided by Charles Schwab, Hong Kong
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