2019 Second Quarter

Despite numerous headwinds, 2019 is gearing up to be a celebratory year with record-breaking achievements on President Trump’s infamous tweets on trade continue to spark serious disputes between the world’s most influential superpowers, as a fickle Federal Reserve (Fed), rising recessionary fears, and the upcoming U.S. presidential election top the list of potential domestic risks. Mix in a global economic slowdown, Brexit uncertainty, Italy’s budget crisis, escalating tensions with Iran, and the long-running political crisis in Venezuela, and you have the perfect recipe for a volatile market. While most of these headlines serve as daily noise to give investors both sugar highs (and sugar crashes), we still believe that investors must be prudent with their investments and remain committed to their long-term financial plans.

With the U.S. economy poised to notch the longest economic expansion in the history of our country in July (121 months), investors can no longer count on tax cuts, quantitative easing, or early-cycle “bounce back” growth to support the market. Assuming the trade war does not escalate, our Chief Economist, Dr. Scott Brown, believes this expansion will continue as the Fed is likely to cut short-term interest rates not just once, but twice, before the end of the year. Elevated business and consumer con­fidence, robust employment conditions, and expectations for healthy consumer spending trends should lead to U.S. Gross Domestic Product (GDP) growth of 1.9% for 2019. While risks have risen, the expectation is that the U.S. economy will not slip into recession over the next 12 months, which is critical in developing our outlook for the capital markets for the next year.

Bonds

“What’s normal anymore?” Given historical precedent, the longevity and strength of the economic expansion, combined with record budget deficits, should have led to higher interest rates. However, this has not been the case. In fact, global interest rates have con­tinued to grind lower and the yield curve remains flat/inverted, depending on the maturities you examine. According to Managing Director of Fixed Income Research, Doug Drabik, central bank bond purchases (particularly in Europe and Japan) have led to more than $13 trillion in negative-yielding sovereign debt. Demo­graphics are also playing a part, as retiring investors transition from risk assets to income-generating securities.

U.S. Treasuries have traditionally been the “safe haven” destina­tion for much of the fixed income world. On a comparative basis, would you prefer a 10-year U.S. Treasury bond yielding 2.01% or a 10-year German bund yielding -0.33%1? The answer is obvious, and the excess demand for U.S. Treasuries will likely keep domestic interest rates lower for longer. The likelihood that the Fed will cut rates in order to preserve the economic expansion, combined with unattractive interest rates overseas, has led us to reduce our year-end target for the 10-year Treasury yield to 2.4% (from 2.75%). From a sector perspective, we still prefer emerging market bonds and investment-grade bonds over high yield.

Equities

To move higher, the equity markets need to shed the “braces” of negativity surrounding trade fears and recessionary concerns. If this does occur, we believe record earnings should continue to propel the equity markets higher. We reiterate our S&P 500 year-end target of 2946. However, should the trade war with China escalate, Managing Director of Equity Portfolio & Tech­nical Strategy, Mike Gibbs, estimates that S&P 500 earnings will fall by ~4%, leading to more uncertainty and downside potential lthe equity markets need to shed the “braces” of negativity surrounding trade fears and recessionary concerns. If this does occur, we believe record earnings should continue to propel the equity markets higher. We reiterate our S&P 500 year-end target of 2946. However, should the trade war with China escalate, Managing Director of Equity Portfolio & Tech­nical Strategy, Mike Gibbs, estimates that S&P 500 earnings will fall by ~4%, leading to more uncertainty and downside potential

Oil

There is typically a negative correlation between commodities and the dollar. Tailwinds that previously supported the dollar continue to fade, particularly as the Fed appears set to cut interest rates before year end. As a result, we forecast the dollar weakening slightly to $1.15 versus the euro before year end. A weaker dollar, fading global oil inventories, and the new International Maritime Organization (IMO) standards set to take effect in January 2020 should support oil prices. Our forecast is that oil will bounce back to $70/barrel before the end of the year.

Entrenched: Trade Warfare

Trade tensions between the United States and China have been a hallmark of President Trump’s time in office and a major market overhang that threatens to initiate a decou­pling of the world’s largest economies, disrupting supply chains, and potentially hitting company earnings in the process. It has been over two years since the initial face-to-face meeting between President Trump and China’s President Xi at Mar-a-Lago, at which time a 100-day plan to address broad economic concerns was put into action.

ARE WE IN A TRADE OR TECH WAR WITH CHINA?

Initial optimism in early 2017 quickly faded as the two sides could not come to an agreement on key market access, intellectual property protection, and technology transfer requirements that remain at the center of talks. The back-and-forth nature of these negotiations is tied to a reality that is gaining greater apprecia­tion: the talks are less about overall trade imbalances, and more about safeguarding future U.S. economic, technological, and military interests. In short, we believe the Trump administration views this as a battle for supremacy. We have noticed more atten­tion on the day-to-day or tweet-by-tweet coverage of the fight (rather than a conversation about why we are in a conflict), the objectives of the Trump administration, and whether China could ever agree to these potential changes. In this article, we will attempt to outline some of the key aspects of this trade war.

GAME CHANGER: U.S. TECH CENTRAL TO NATIONAL SECURITY

A government-wide effort to strengthen the defense of U.S. “foun­dational” technologies began in 2017 under the Trump administration to preserve U.S. leadership in tech that will have future military applications such as advanced robotics, artificial intelligence, and quantum computing. The new approach can be thought of as threefold: enhanced domestic foreign investment reviews, commercial controls on tech exports, and ramped-up criminal prosecutions against the theft of corporate secrets. All three take direct aim at China’s efforts to close the gap in techno­logical know-how and begin to challenge the established U.S. tech industry for global superiority. The widely-publicized “Made in China 2025” initiative laid out China’s ruling party’s plans in this area, establishing domestic and international market share tar­gets for China’s firms competing with advanced U.S. tech by 2025 and beyond. In effect, the Trump administration has moved to set defenses against access to U.S. tech that is aimed at directly threatening U.S. dominance in the tech space by a foreign com­petitor, especially if it could have a military application. More broadly, China hardliners in the Trump administration view com­petition in the tech space as the new ideological frontier to determine the values of the emerging tech landscape – a modern day “Cold War” scenario.

The more direct challenge to China’s behavior came in August 2017 with the administration’s so-called “Section 301” investiga­tion into “any of China’s laws, policies, practices, or actions that may be unreasonable or discriminatory and that may be harming American intellectual property rights, innovation, or technology development.” The investigation led to the tariff imposed on $200 billion of Chinese imports directly targeting China’s advanced manufacturing industry central to its “Made in China 2025” devel­opment goals. The investigation found that China utilizes joint venture requirements (U.S. firms need a Chinese partner to con­duct business in China), forced tech transfers (business licenses are only granted to firms who agree to transfer critical intellectual property to their Chinese partner), foreign direct investment (Chi­nese companies invest in U.S. companies to gain access to new technologies), and unauthorized network intrusions (cyber espi­onage) to cause direct harm to U.S. industry. U.S. companies seeking to enter China’s markets are frequently required to partner with a domestic Chinese partner or detail critical com­mercial information to government agencies in order to gain licensing approval. These requirements provide crucial access to U.S. tech that can be replicated by Chinese competitors, according to the investigation. The report further details cyber espionage and hacking efforts targeting U.S. companies for theft of trade secrets. A November 2018 follow-up report concluded that China had “failed to make structural changes” and to “adopt U.S. rec­ommendations for reforms” to adequately address U.S. concerns. The tech battle remains a pivotal issue in ongoing talks, and is trending toward escalation for the remainder of 2019.

STAGE SET FOR SIGNIFICANT ECONOMIC RESTRICTIONS TARGETING CHINA

One weapon the Trump administration has floated throughout the trade negotiations is the activation of the International Emergency Economic Powers Act (IEEPA), a set of national security powers that allows for broad restrictions of certain commerce that is deemed a threat to the U.S. In May, President Trump formally invoked IEEPA to secure emerging 5G networks by banning the acquisition of certain foreign-produced equipment that could allow adversaries to exploit vulnerabilities. Although the order does not name China or Chinese companies directly, it alludes to industrial espionage-type threats that the U.S. has described to allies in its push to restrict the use of Chinese 5G equipment around the world. Under the order, the Department of Commerce has until mid-October to establish regulations on specific restrictions. The activation of IEEPA is yet another warning shot at China showing that we could see this battle move from company-to-company restriction (like Huawei) toward a technology-to-technology restriction in the coming months unless negotiators are able to reach agreement on significant changes to China’s economic practices.

PRESIDENTIAL POLITICS AND CLASH OF GOVERNANCE SYSTEMS FURTHER COMPLICATE PATH TO A DEAL

The China trade fight is arguably the most popular policy position of the Trump presidency. Members of Congress may question the style of the negotiations, but few are willing to publicly question the substance of the fight – especially on strengthening protec­tions for U.S. tech. Fighting China in a trade war is easier for Trump to defend than a weak deal, increasing the likelihood that this fight lasts beyond the 2020 election. We believe one of the biggest threats to President Trump’s reelection would be a market sell-off or weakening economy. Either could cause the president to soften his stance toward China, but that is not a given and could embolden China to hold out.

Politically, securing a deal in the short term presents advantages for both sides, but opportunity for miscalculation is heightened in the long term. Reaching a deal would provide a market boost in the U.S. and would play well for China’s Xi for preserving (for the time being) the relationship with China’s largest market. In the longer term, the incentives do not align as well. Xi Jinping’s term as China’s leader will continue well beyond Trump, but the U.S. may experience a change in administration with the 2020 elec­tion. From that perspective, the trade fight may be prolonged if China’s leaders decide to “weather the storm” for the time being. A less comprehensive deal or continuously stalled negotiations may result in tariff escalation or other significant economic restrictions. Escalation points could come right in the heat of the 2020 presidential campaign, which can damage Trump’s eco­nomic message or provide a political incentive to once again increase pressure on China. As we noted earlier, we expect trade relations with China to remain a key theme of the Trump presi­dency, even in the event of a deal struck sometime in 2019.

KEY TAKEAWAYS:

• U.S./China trade tensions have been a hallmark of President Trump’s time in office and a major market overhang that threatens to initiate a decoupling of the world’s largest economies, disrupting supply chains, and potentially hitting company earnings in the process.
• China hardliners in the Trump administration view competition in the tech space as the new ideological frontier to determine the values of the emerging tech landscape – a modern day “Cold War” scenario.
• The China trade fight is arguably the most popular policy position of the Trump presidency. We believe one of the biggest threats to President Trump’s reelection would be a market sell-off or weakening economy. Either could cause the president to soften his stance toward China, but that is not a given and could embolden China to hold out.
• Politically, securing a deal in the short term presents advantages for both sides, but opportunity for miscal­culation is heightened in the long term. Reaching a deal would provide a market boost in the U.S. and would play well for China’s Xi for preserving (for the time being) the relationship with China’s largest market.

Caught in the Crossfire: Market Momentum

The S&P 500 rose 26% from its December lows by the end of April, with positive trade negotiation developments, a pivot to a neutral stance by the Federal Reserve (Fed), better economic readings, and lower interest rates restoring investor confidence. However, a fallout between the U.S. and China rekindled trade tensions, triggering a 7.65% pullback in equities in May. The S&P 500 recovered, rallying to a new all-time high on a dovish Fed message at the June meeting and news that Trump and Xi plan to meet at the G20.

U.S./CHINA TRADE TENSIONS RE-ESCALATE

Since the May 5 tweet by President Trump, the U.S. has increased tariffs on $200 billion worth of Chinese goods to 25% (from 10% previously) and threatened to place another 25% in tariffs on the remaining $300 billion worth of Chinese exports to the U.S. Additionally, the dispute has escalated to the use of non-tariff barriers (i.e., U.S. ban on Huawei equipment). Heightened trade tensions come amidst a global backdrop that has softened dramatically over the past 12 months, particularly on the manufacturing side of the economy. While the U.S. economy has held up much better than many other places in the world, it too is experiencing softening manufacturing trends. In response, central banks around the world have shifted to a more dovish tone, talking up monetary policy support if the economic outlook continues to deteriorate. Trade conflicts are top of mind for central bankers and investors alike, and all will be monitoring developments at the G20 meeting in Japan where Presidents Trump and Xi are set to meet. Regarding U.S./ China trade, although both sides appear entrenched, our base case remains that cooler heads will prevail at some point, and something will eventually get done. The last meeting between the two presidents (in December 2018) led to a three-month delay on a tariff hike, and the current state of talks makes a similar result the most likely outcome (according to Washington Policy Analyst Ed Mills). We believe the market in general is trading as if the next tranche of tariffs gets delayed, and this is our view of what will likely transpire. That being said, an escalation in tensions would likely be the catalyst for a market pullback in the short term.

FUNDAMENTAL OUTLOOK

S&P 500 sales growth is expected to reach the 5% level for 2019. Earnings growth expectations of nearly 4% are below the long-term average of ~6%, however the moderating trend is not alarming after 20% growth in 2018. Rising wages, tariffs, and slowing economic growth are applying pressure to margins which have declined by~6% since tariffs went into effect in September 2018. Lower margin estimates pushed consensus on S&P 500 2019 earnings down to $166.77 and near the $166 level we have maintained for months.

The outcome of trade negotiations will impact the next direc­tional move for earnings estimates. Should the trade battle result in 25% tariffs on all trade between the U.S. and China, our esti­mate declines to $163 (we apply a 4% hit over 12 months pro-rated for six months left in 2019). On the flip side, positive trade resolu­tion (and improving economic and fundamental momentum) will likely allow estimates to move higher, possibly reaching the $169 incorporated in our bull case scenario.

The current S&P 500 P/E of 17.5x is not unreasonable, given low inflation and interest rates, as well as the dovish message from the Fed. However, with the U.S./China trade deal unknown (as of this writing on 6/24), it may not adequately discount the risk either. Our base case year-end S&P 500 expectation remains 2946 (17.75x $166 EPS) for now. It is our belief that the two sides will do enough to soothe investors over the path of negotiations; and with the Fed likely to lower rates, a case can be made for a higher valuation target.

In our bear case scenario, we see an S&P 500 level in the mid 2400s (15x $163) if the trade battle lingers and higher tariffs transpire, put­ting downward pressure on economic growth and earnings trends (with Fed cuts providing support). The 15x P/E multiple used is in line with the valuation seen at market lows over the past five years. We place a low probability on that outcome, however the risk is still there for now. In our bull case scenario of 3211 (19x $169), a trade deal must transpire and tariffs must be eliminated on both sides. This would boost sentiment, economic momentum, and earnings growth. The 19x P/E assumption is in line with the market’s peak trailing 12-month P/E last September, as well as the historical median when inflation is in the 2-2.25% range. Given softening man­ufacturing trends and an increasing possibility for lingering trade issues, we also place a low probability on this outcome for now.

PORTFOLIO POSITIONING

From a global perspective, the U.S. equity market has held up better than most areas around the world (and is also exhibiting better fundamentals). Relative strength for the U.S. (vs. the world) broke out to new highs through the volatility. Therefore, we favor the U.S. over other regions, with a bias toward large-cap growth companies. Next favored are emerging markets given the Fed’s dovish message, which may cause weakness in the U.S. dollar.

SECTOR ANALYSIS

Some market sectors have proven to be more sensitive to tariffs and trade tensions than others. Semiconductors and hardware areas of the Technology sector, Materials, the multi-line retail area (of Consumer Discretionary), and specific transportation subsectors (of Industrials), stand out as several groups most influ­enced by trade negotiations with China. On the flip side, companies with more U.S.-centric business models, along with defensive sectors such as Utilities and Real Estate are benefiting from lower rates and have performed best since early May. At the subsector level, there can be significant deviations between global exposure from one stock to the next, and this is important to consider when positioning your portfolios (based on your risk tolerance) in the current environment. We favor companies with more U.S. revenues since trade is unlikely to go away anytime soon with President Trump making it a campaign topic.

Economic Snapshot

The near-term outlook has been mixed, with a healthy consumer sector, but softness in business fixed investment. With the May 10 increase in tariffs on Chinese goods, the drag on U.S. growth has become more noticeable and a further escalation (25% tariffs on the remaining $300 billion or so in Chinese goods) would likely put the economy on the cusp of a recession. The Federal Reserve (Fed) is poised to lower short-term interest rates, if needed. Risks to the growth outlook are weighted to the downside, but much depends on whether we’ll see a resolution of trade tensions.

Favorable:

Neutral:

Lawrence V. Adam, III, CFA, CIMA, CFP- Committee President Chief Investment Officer, Private Client Group

Michael Gibbs Managing Director, Equity Portfolio & Technical Strategy

Nick Goetze Managing Director, Fixed Income Services

Scott J. Brown, Ph.D. Chief Economist

Chris Bailey European Strategist, Raymond James Euro Equities*

Doug Drabik Managing Director, Fixed Income Research

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Material created by Raymond James for use by its advisors. The information contained herein has been obtained from sources considered reliable, but we do not guarantee that the foregoing material is accurate or complete. Information provided is general in nature, and is not a complete statement of all information necessary for making an investment decision, and is not a recommendation or a solicitation to buy or sell any security. Past performance is not indicative of future results. There is no assurance these trends will continue or that forecasts mentioned will occur. Investing always involves risk and you may incur a profit or loss. No investment strategy can guarantee success. The S&P 500 is an unmanaged index of 500 widely held stocks. The Dow Jones Industrial Average is an unmanaged index of 30 widely held securities. It is not possible to invest directly in an index.

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