Investors can credit the Fed once again for the market's revival thus far in June. The buying is fueled by expectations of three rate cuts by no later than December. Is that wishful thinking?

 

While only 23 percent of investors expect a rate cut next week when the Fed meets, 83 percent do expect a cut in July. The odds of another cut in September are now at 63.8 percent, with a third cut in December, which is expected by over half of market participants.

 

Given that the Fed's job description is to keep inflation under control, while supporting robust employment, one or the other of those variables will need to change in order for the Fed to cut rates. The inflation rate is still below the Fed's stated targets, so that shouldn't be the issue, which leaves jobs as the area of concern for the Central Bank.

 

Over the last few weeks, job creation has slowed down, but so far the data does not indicate the unemployment rate is set to skyrocket. It is true that warning signs are flashing for economic growth both here and abroad, but the U.S. is still expected to grow by 2.2-2.5 percent this year. Most economist models indicate a further slowing to slightly under 2 percent for the U.S. economy in 2020, but that still results in an acceptable performance for an economy that is on its 10th year of expansion. 

 

I guess the real issue that makes forecasting by the Fed, investors, and myself so difficult is the ongoing trade and tariff threats that will most likely decide the fate of the global economy. Three rate cuts might be justified if the two antagonists (Trump and Xi) meet at the G-20 at the end of June and fail to compromise. The kind of tariffs Donald Trump is threatening to levy on China would certainly put a big dent in global trade and shave a half percentage or more off the U.S. economy next year, if not sooner.

 

On the other hand, if the two agree to disagree, but continue to negotiate through the summer, corporations would still be living on borrowed time, but won't invest. Our farmers and other exporters would continue to try doing business within the continuing status quo of uncertainty. That sort of atmosphere, while not a robust business climate, might not be sufficient enough to justify a rate cut by the Fed.

 

In this land of the unknowns, therefore, we are left with throwing the bones and/or reading tea leaves to come up with all sorts of what-if's. Story lines like "Donald Trump needs a China deal, otherwise, the economy slows, the stock market plunges, and he loses the 2020 Election."

 

Then there is the China sub-plot: "China's game plan is to procrastinate until after November 2020, or at least wait until the economic pain in the U.S. is such that Trump caves-in and is willing to strike a better deal than he is offering now."

 

If one looks at the action in the bond market, where interest rates have fallen to multi-year lows, the consensus seems to be gloom and doom. But that is nothing new--bond investors are a gloomy mob even at the best of times. If you look at the stock market, which is only a few percentage points away from historic highs, you could say that the future is rosy and there are blue skies ahead. Which is right, since they can't both be correct?

 

Maybe it simply comes down to whether you are a half-empty or half-full kind of investor. Donald Trump is definitely in the camp of those that believe the stock market should go higher. If that means the Fed should cut interest rates and be dammed the consequences, then so be it!

 

In the other camp are those who get hurt when interest rates fall. Retirees, pension funds, and all those who shun undue risk in exchange for a steady income. While those voices do not appear to be well represented in today's environment, they do represent a sum of money that dwarfs that of the equity market. Yet, they also have the reputation for being smarter than equity investors and are right more times than they are wrong.

 

You would think that a non-farm payroll report that was way below expectations would give investors pause. After all, when the pace of employment slows, it usually means that the economy is slowing as well. So why did the stock market spike higher?

 

It comes down to what the Fed may do. Contrary to many investors' belief that tariffs (or the lack thereof) are the critical element in the stock market's fortunes, I believe the actions of the U.S. central bank trump Trump's antics on the trade front. 

 

A look back to the last quarter of 2018 reveals why I believe this is so. While the press gave plenty of space to the on again, off again China/U.S. trade negotiations, the Fed's program of raising interest rates is what sent the markets into decline. In December, once the Fed realized that raising rates in an economy that was not overheating was a mistake, they reversed course, announcing any further rate rises were "on hold" until the data dictated otherwise.

 

From the end of December through the beginning of May, the U.S. stock market rocketed higher, regaining much of its 19 percent fourth quarter loss, even though no progress had been made on the trade front whatsoever.

 

Fast forward to last month. Trade negotiations between the U.S. administration and their Chinese counterparts hit a brick wall. Markets dropped more than 5 percent. Last week, The President's sudden threat to raise tariffs on Mexican imports by 5 percent added to the carnage with an additional drop of 2-3 percent.

 

While I wrote last week that I doubted (and still do) that those Mexican tariffs would actually be implemented, as of today nothing has changed on the trade front and yet the markets are up considerably. Look to the Fed for an answer.

 

The threat of new tariffs both in China and now Mexico, on the back of an economy that is growing moderately, triggered concerns that we could be setting ourselves up for a recession as soon as 2020. U.S. Treasury bond prices plummeted and within days investors were speculating that the Fed may need to move off their neutral stance and actually cut interest rates.

 

Now the market is betting on anywhere from two to three interest rate cuts by the Fed over the next 12 months. That is a drastic reversal of course from a mere six months ago when most believed the opposite would occur (more rate hikes).

 

Within this context, the jobs report was further evidence of an economic slowdown, which then bolstered expectations that the Fed would need to cut rates sooner rather than later. As such, investors have been conditioned to expect that looser monetary policy by the Fed translates into higher stock prices. It has been the way of the world for the last decade, so weaker macro numbers equate to buy, buy, buy.

 

As a result, with the Fed at our backs, I expect stocks to continue higher. How high, you might ask? At least to the old highs of the S& P 500 Index (2,944), which is a little under 100 points upside from here. Could it trade even higher? Yes, if the following occurs: Tariffs on Mexico are not levied, some accommodation with China on trade negotiations is made (a mini breakthrough) and/or the Fed makes a stronger statement on rate cuts.

 

On the downside, second-quarter earnings, which are coming up, might not be up to expectations, in addition to further escalation in Trump's trade war (more tariffs, counter tariffs, etc.). That would not only cap the markets on the upside, but could also establish a rather wide trading range throughout the summer with the lower boundary equating to the recent lows on the S&P 500 Index (2,744).

 

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.