No question about it, the president's decision to impose 5 percent tariffs on all Mexican imports by June 10 caught investors flat-footed. Combined with the on-going war of words with the Chinese on tariffs, markets worldwide fell sharply this week. Is a relief rally in the cards?

 

Chances are that next week, we should see a rebound. How much and over what period of time will largely depend on what happens next on the trade front. My thinking on the Mexican issue thus far is this: Trump is using trade with Mexico to force their government to turn back (instead of encouraging) Latin American refugees from our border.

 

You may disagree, but I believe President Trump's heavy-handed actions toward Mexico over the past two years has resulted in the immigrant problem we have today. By "Making America Great Again" at the expense of every other nation on earth (with the possible exception of Russia), Trump has broken, reduced, and/or trashed past agreements, both spoken and unspoken, by our former allies, which includes Mexico.

 

In the case of Mexico, for years we had successfully enlisted their cooperation in turning back refugees at their borders from Latin America and, where they could, reduce the number of their own citizens from entering the U.S. illegally. It was not a perfect solution, and a steady trickle of refugees continued to find their way over our borders, but it was manageable. Trump, recognizing that he could use immigration as a campaign issue among a certain segment of the population, hammered Mexico unrelentingly.

 

Why, under those circumstances, would any country continue to cooperate voluntarily with the U.S. and our protectionist president? They did what made the most sense for them, just like Trump does for his base. They simply stepped aside and let the flood gates open.

 

Unable to stem the tide, our immigration force is drowning. Donald Trump is using economic trade to force a solution to a problem of his making. Although Mexican leaders have responded by taking a hard stance, I suspect that Trump will get his way, at least temporarily.

 

The markets expect the same. Mexico, unlike China, cannot afford a protracted trade war with its neighbor and largest trade partner. It is one reason stocks on Friday were "only" down one percent or so. Given that the administration has also started the ratification process on the new, Mexico-Canada-U.S. trade agreement this week, it seems obvious that Trump is injecting immigration into what until now been a purely economic agreement.

 

China, as I warned last week, continues to ramp up its hardline response to U.S. trade demands. The administration's moves against Huawei, China's telecom behemoth, have now elicited a response. China's Ministry of Commerce is reported to be compiling a list of "unreliable entities." These are companies and individuals that have cut off business with Chinese companies (like Huawei). It confirms investors' worst nightmares, sending semiconductor and other technology stocks lower.

 

In addition, China is threatening retaliation on other fronts. China accounts for 80 percent of the production of rare earth, used in the manufacture of things like cell phones, rechargeable batteries, DVDs, computer memories and much more. It has floated a veiled threat to cut off exports to the U.S. in the future. That would cripple production across a wide range of American industries.

 

In the short-term, we can expect to see the S&P 500 Index test the 2,700 level, give or take 25 points. That would still leave the entire pullback from the highs no more than about 8 percent. Pundits may make a big deal about breaking through the S&P's 200-day moving average (DMA), but I believe it will rebound. This decline is perfectly reasonable after the double-digit gains we have enjoyed since December.

 

If it were not for computer-driven trading, it might actually be funny. Financial markets are careening up and down on a daily basis based on the next tweet or comment from the Trump administration or its counterparts in China. We could see more of the same next week.

 

Rhyme or reason has truly left the station. Day by day, the trade war of words is accelerating. This week, the U.S. banned China's largest technology company, Huawei, from doing business with American companies. The president accused the company of espionage. The Chinese responded by threatening to drop trade negotiations. Markets collapsed, led by semi-conductor and technology stocks.

 

A day later, the administration walked back their ban, at least temporarily, once they realized the entire U.S. semiconductor industry would be crippled by their move. Markets spiked higher. Then, Stephen Mnuchin, the U.S. Treasury secretary, admitted there was no planned dates to resume trade talks — pow, markets fell again.

 

Thursday, the president, in a free-wheeling news conference, announced a trade deal with China will happen "fast." Confused investors jumped back into the markets chasing stocks up on Friday morning and down in the afternoon.

 

Over in China, there also appears to be an escalation in the tariff/trade verbiage. The Chinese government-controlled media have stepped up its anti-U.S. rhetoric, quoting Chinese officials, who are increasingly painting America and its leaders as irrational and unreasonable. A protest song of sorts has hit their air and internet waves, gaining massive popularity among the billions of Chinese citizens.

 

Rather than caving-in to our demands, it appears that China is hardening its stance and intensifying its "Made in China 2025" import substitution program. Readers may recall that China's long-term economic strategy is to become self-sufficient in producing the goods and services they need to supply their increasingly affluent population. They envision a centrally planned mercantile society that, in the end, will cease to depend on the U.S. and its imports and rely solely on domestic production.

 

While China would prefer to wean its need for U.S. goods and services gradually, over a period of a few more years, if push comes to shove, they seem willing to take the hard road, and cut off much of their trade with the U.S. if negotiations fail. After all, while the population may suffer and economic growth would slow, it's not as if the Chinese populace can vote Xi Jinping out of office.

 

Xi, last week, actually gave a speech in Yudu, a small county where Mao Tse Tung's Long March began, 85 years ago. The two-year march, over some of China's most rugged and difficult terrain during the Chinese civil war, is the stuff of legends within China. Xi's message was clear: China may be in for another long march of "enduring hardship" and should be prepared if negotiations fail.

 

Despite this war of words, the majority of investors still believe that a deal will be done and done fairly quickly. As such, any hint that reflects positively on the trade talks is an excuse to buy. This tendency is exasperated by computers that are programmed to respond to certain key words (that signal it to buy or sell the markets).

 

Computers cannot reason. They do not know if the president's tweets or statements are backed up by facts and they don't care. Neither, evidently, do human investors. I can see this continue to play out until June 1. That's the date when China's second round of tariffs will be levied on U.S. goods. That's next weekend. If no breakthrough occurs by then, and I don't believe it will, then expect the next shoe to drop and the markets with it.

 

The old adage "sell in May and go away" seems to be working this year. In short order all three averages experienced a down draft over the past few days that amounted to about a 5 percent decline in total. Is there more to go on the downside?

 

If I were a betting man, I would say the odds are in favor of more declines in the weeks ahead. I base that bet on the assumption that it will take at least until the end of June before we get anymore clarity on whether or not President Trump is willing and able to salvage a trade deal with China.

 

By now, most readers are aware that there has been an abrupt change in expectations on whether or not the tariff trade wars will end anytime soon. Both countries have escalated their rhetoric and at the same time made clear that more tariffs are in the works unless a resolution can be successfully negotiated.

 

There is a G-20 meeting coming up at the end of June. Reports are that President Trump and his Chinese counterpart, Xi Jinping, will meet at that time. Until then, investors can expect this war of words to continue. Traders will be cocked and ready to pull the trigger on every tweet, comment, or action by either side. I expect markets to respond (up or down) with a vengeance.

 

At the same time, expect to read and hear how tariffs are bad for worldwide economic growth. The bears will begin warning that Trump's actions towards China will cause the U.S. economy to tip into recession next year. I expect the inverted yield curve will be resurrected and demands that the Fed cut interest rates immediately will likely occupy much of the headlines. And there is some truth to that. As long as a global trade war is a possibility, corporate investment is not likely to rise, nor should it.

 

We have heard this all before and may hear again in the months ahead. The facts are that while some progress can and most likely will be made in forging a trade agreement with China, the real difficult issues, such as intellectual property safeguards, will take much longer than anyone expects.

 

One troubling aspect in the president's recent remarks is his willingness to keep tariffs in place, not only in China, but in his negotiations with other countries. We knew when he was elected that there would be a protectionist flavor to his economic policy, but as time goes by his stance has hardened.

 

The last time the United States actively used tariffs as an economic policy weapon was back in the Thirties. As readers may remember, those policies by us as well as our trading partners ushered in the Great Depression. Could it happen again?

 

Some argue that the world has changed, and circumstances are different. Protectionism, after years of giving away the shop in trade deals such as NAFTA, is just leveling the playing fields. That may be accurate, but it flies in the face of every economic principal I have studied. If that is truly the endgame here, let's hope it turns out better than the vaunted tax cut that was supposed to supercharge the economy and lead to massive investment in this country.

 

As the drama continues to play out on a daily basis, look for the markets to remain unsettled. While the ups and downs are nerve-wracking and unpleasant, it's part of a necessary and overdue reset in equity prices. I believe it is temporary and in time will lead to higher prices overall.

 

Volatility in the form of U.S. trade tariffs levied on China cut through investors' complacency with a vengeance this week.  It took less than three days to drop the markets by 3 percent. Is it over or do we have another 5 percent or so to endure?

 

My bet is that it is over — for now. Sometime during the on-going trade negotiations occurring in Washington today and tomorrow, the thorny trade issues, (such as intellectual property (IP) protection for U.S. companies) will be kicked down the road. A compromise on other, easier issues will be announced as "on-going" (although not inked) and the Chinese delegation will fly home in an atmosphere of reconciliation.

 

From the president's perspective, China, after agreeing to a list of breakthroughs in the trade negotiations in Beijing two weeks ago, "broke the deal." Over a half-dozen important "firsts" involving IP rights, as well as other structural rules and regulations that have hampered U.S. companies doing business in China, were first agreed to as of two weeks ago. A week later, half of them had been deleted from the formal draft agreement sent to Treasury Secretary Steven Mnuchin and Chief Trade Negotiator Robert Lighthizer.

 

The move surprised the negotiators and infuriated the president. Sunday night, the president took to Twitter and threatened to raise U.S. tariffs on $200 billion of Chinese goods from 10 percent to 25 percent. The tariffs took effect Friday morning. The Chinese have responded by preparing their own additional tariffs on U.S. goods.

 

As you might imagine, the Dow dropped 500 points or more on Monday, spiking higher on Tuesday, down again Thursday, and by Friday no one (including the Algos and their computers) was sure what to do next so the averages spent the day moving up and down just because. The volatility index, which is a measure of fear and loathing in the stock market, exploded higher, putting even more pressure on world markets.

 

The Chinese market, as well as other emerging market indices, cratered. One of China's main indices, the Shenzhen Index, dropped over 7 percent in one day. As the markets fell, the financial media trotted out all the "what if" scenarios they could cram into their studios between commercials. Hopefully, you turned it all off.

 

Why, therefore, am I not more concerned? Well, for one thing, all this brouhaha has only pushed markets down by 2-3 percent. In the grand scheme of things, that's simply one of three or four normal pullbacks you should expect each year in the stock market. And, on average, you can expect at least one 10 percent correction per year. You should remember that.

 

Granted, if things escalate from here on the trade front, we could see another 5 percent downdraft or so. But it still wouldn't be the end of the world, given the gains we have enjoyed so far this year. You might argue that I am too complacent, given the impact that higher tariffs could have on U.S. economic growth, let alone global growth.

 

If economic activity did decline, I would fully expect the Fed to come to the rescue, cutting interest rates in order to support the economy, while goosing the stock market once again. In fact, one could theorize that the president is thinking along these same lines when he said on Friday that "there was no hurry" in lifting these new tariffs.

 

I have been warning readers for weeks that all signs pointed to a market pullback. All that has happened is that we are now in one. In the short-term anything could happen. We could bounce from here, get back to the old highs and fail. Things might also quiet down on the trade front for a week or two, while investors' focus may switch to what's happening in Iran or North Korea. Those areas could also cause markets to fluctuate. Take it in stride.

 

My advice is to look beyond these events and keep focused on the fact that there is still a whole lot of good news supporting the markets just under the surface.

 

Bill Schmick is registered as an investment adviser representative and portfolio manager with Berkshire Money Management (BMM), managing over $400 million for investors in the Berkshires.  Bill's forecasts and opinions are purely his own. None of the information presented here should be construed as an endorsement of BMM or a solicitation to become a client of BMM. Direct inquiries to Bill at 1-888-232-6072 (toll free) or email him at Bill@afewdollarsmore.com.

Some people believe we are in a "melt-up." It is where the simple weight of money pouring into the U.S. stock market continues to carry stocks ever higher. Whether that qualifies as an investment thesis, or simply a lame excuse to justify record highs, it matters little to the bulls.

 

It is true that this past week, we actually witnessed a rare event — a two-day, 50-point drop in the S&P 500 Index — before stocks recovered.  But good news on Friday morning (job gains in the economy came in at 236,000) cheered investors. It was largely a goldilocks report where wage gains (considered inflationary) were flat for the month, bringing the the average hourly earnings rate up to 3.2 percent year-over-year.

 

Overall, the official U.S. unemployment rate is now 3.6 percent, which is the lowest level since 1969. It brings the total number of monthly job gains to 103 in a row, which has never happened before. Given that it is also the best start in the year for stocks since 1987, is there any wonder that exuberance is the prevailing mood on Wall Street (and in the White House)?

 

Even the bears, whose numbers are expanding by the way, admit that if we did suffer a correction, it would be, at most, shallow and sharp. That's the kind of correction you want, if and when it occurs. I have been reporting faithfully each week the bullish rise in investor sentiment and, although it remains flattish at 55.7 percent bulls, it is still quite high.

 

Earnings season, which is 80 percent complete, turned out to be better than expected in the minds of most investors.  And although the Fed did not cut interest rates this week at their FOMC meeting, I have to wonder if anyone really expected that to occur?

 

As we move into spring, it appears that the wall of worry we have been climbing is crumbling. We should finally receive a verdict on the U.S./China trade agreement as soon as next week, according to administration officials. Talks in China last week went well, and the Chinese delegation will be back in Washington this coming week to hammer out more details.

 

Some argue that a successful conclusion to this issue, which has been over-hanging the markets for almost two years, is largely discounted. Could we get a "sell on the news" reaction if a deal is announced?

 

We could, but I think it would depend on the level of the markets at the time. If, for example, the S&P 500 Index were to be trading above 3,000 or so, (another 70 points higher from here), then yes, it could be an excuse for some profit-taking.

 

And while everything seems rosy for the economy overall, we don't want it to get too much stronger in the short term. Remember, the Fed is data dependent. If, for example, the central bank did cut rates by a percentage point, as the president asks, in order to goose the economy, you can bet the next move by the Fed would be to reverse that and hike rates.

 

I believe the Fed's about face in interest rate policy last December is the real reason the market is where it is. If investors believed that the Fed's easy money policy might change, the markets would plummet. The Chinese economy might also be a factor.

 

In case you haven't realized this yet, China, as the world's second largest economy, has a substantial impact on overall global growth, including growth and inflation within the United States. Recently Chinese authorities have relied on fiscal spending to support their slowing economy, which has been hurt by the tariff issues.

 

A trade deal would be as good for China as it would be for the U.S. It could boost growth in both economies. But what's good for economies is not always good for stock markets. Rapid growth, on top of moderate growth, might ignite inflation.

 

In the past, Chinese demand for raw materials to fuel their growing economy has sparked inflation globally. If that were to happen again, it could force the Fed to reverse policy, raise rates, and cause a repeat of last year's sell-off. While this scenario is only one among several possibilities, it is something to keep in mind, given that we are within a week or two of a potential compromise solution in the trade talks.

 

Bill Schmick is registered as an investment adviser representative and portfolio manager with Berkshire Money Management (BMM), managing over $400 million for investors in the Berkshires.  Bill's forecasts and opinions are purely his own. None of the information presented here should be construed as an endorsement of BMM or a solicitation to become a client of BMM. Direct inquiries to Bill at 1-888-232-6072 (toll free) or email him at Bill@afewdollarsmore.com.