Perfect Storm Threatens Bull Market After Rallies on Fed, Trade Talks

“Rate cuts, a fairly resilient economy, high earnings beat rate, and the recent pullback of valuations will convince some investors to buy the dip”, wrote Deluard in a note to clients. However, “Stock market declines will resume in the fall, with a perfect storm of negative events”, he added.

Investor expectations of Fed rate cuts and a U.S.–China trade deal have sent stocks surging within a hair of their all-time highs. But several market strategists say these gains are likely to be illusory and short term. Instead, a perfect storm is brewing that could hammer equity markets in the second half of the year as four major headwinds gather strength, including weaker than expected earnings, a halt to massive stock buybacks, fewer than expected rate cuts, and growing turmoil from Brexit and other convulsions in Europe, according to macro strategist David Deluard at INTL FCStone, per a detailed story in Business Insider.

Deluard is not the only skeptic. A Bank of America Merrill Lynch survey shows investor bearishness is at its highest levels since the financial crisis 10 years ago “with pessimism driven by trade war and recession concerns”, according to chief investment strategist Michael Hartnett. And strategists at Morgan Stanley say the risk of a recession and steep market plunge have increased sharply.

These bearish forecasts come as the major indexes have posted strong gains in June, and jumped again on Tuesday on hopes of an imminent U.S.-China trade deal. The latest catalyst was news that President Donald Trump will hold an “extended meeting” with Chinese President Xi Jinping at the G-20 meeting next week.

What it Means for Investors

The big risk is that any U.S.-China trade deal could fall far short of investor expectations or that the conflict could drag on. For his part, macro strategist Deluard says continued trade tensions risk hurting corporate profit margins. If those margins fail to expand, investors should be prepared for weaker forward guidance in Q2 earnings reports or else be disappointed by weaker than expected earnings in Q3 and Q4. Downward earnings revisions in the past have been detrimental to share prices.

In addition, Deluard says that buybacks, which have played a major role in bolstering the stock market, will be reduced during earnings ‘blackout’ periods when companies prohibit purchases of their own shares. While this pause occurs every earnings season, heightened trade tensions and the fading influence of Trump’s tax plan could intensify the buyback ‘blackout’ effect.

And while markets are currently pricing up to three rate cuts, Deluard believes the current rate of inflation warrants just two cuts. If the Fed fails to meet market expectations, expect to see stocks correct to the downside.

Within Europe, Deluard also says the stock rally could become unhinged by several forces, including how the European Commission deals with Italy’s ‘excessive’ deficit, the expiration of Mario Draghi’s term as president of the European Central Bank (ECB), and the very real possibility that a ‘no-deal’ Brexit will occur.

Looking Ahead

In its latest bear-case forecast, Morgan Stanley presented a bleak scenario should the U.S.-China trade conflict worsen. In the 20% chance that this scenario occurs, Morgan Stanley expects the S&P 500 to fall to 2,400 over the next six to 12 months, the U.S. economy to enter a full-blown recession by 2020 and earnings growth to hit a bottom of negative 14% in 2021.

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