Key Points

  • It’s getting later in the cycle and time to weigh the rising risks, like trade, alongside the continued rewards, like strong economic growth.

  • Earnings growth has been stellar and remains a tailwind; but be wary of a very high expectations bar heading into 2019.

  • Financial conditions are tightening and liquidity is receding…time to look for who’s swimming naked.

When it comes to the connection between economic and/or corporate earnings fundamentals and the stock market, it’s worth considering my oft-expressed view that “better or worse tends to matter more than good or bad.” As a leading indicator, the stock market typically does a great job sniffing out important economic or earnings inflection points in advance. This is why at market tops the data typically looks great, while at market bottoms the data typically looks abysmal. Keep this in mind as you read through this outlook for the remainder of 2018.

Our key theme coming into this year was “it’s getting late,” in reference to the stage of the economic cycle. The key implications noted were the likelihood of rising inflation, tighter monetary policy and greater market volatility. Check. We have also been consistently highlighting protectionism and trade as a market and economic risk. Check.

We are entering the second half of the year in the middle of the S&P 500’s trading range, which has been in place since the correction that began in late-January. Until the index takes out its January high, it’s considered to still be in correction mode. For what it’s worth, only the 1994-1995 correction went longer without turning into a bear market (20% decline or more, using the standard definition). If this was a typical correction, it would have been at or near new highs by now; and the longer that takes, the higher the likelihood that this correction gets worse before it gets better.

Looking ahead, starting with trade

Let’s look into the second half of the year to expand on some of the aforementioned themes, as well as posit some additional themes to consider. Let’s start with trade. Many who are still brushing off a possible trade war often cite the limited impact of the currently-proposed tariffs on gross domestic product (GDP) growth—especially since it’s dwarfed by the benefits of fiscal stimulus. The problem with that argument is that it only considers “first order” effects; while not considering “second order” effects—which include, most importantly, the impact on business and consumer confidence.

Animal spirits, which have propelled everything from hiring, to wage increases, to capital spending plans, could be deflated if there is not an easing in trade tensions soon. In fact, economists’ pessimism about sliding down the slippery slope toward a trade war is already getting reflected in surveys, including those conducted by the National Association for Business Economics (NABE), The Wall Street Journal, Reuters and CNBC.

Other headwinds (and tailwinds)

More broadly, at the midpoint of the year, there continue to be both headwinds and tailwinds for the economy and the market. Trade uncertainty clearly falls in the former. As you can see in the graphic below, I have loosely connected many of these, along the lines of an “on the one hand…on the other hand…” analysis. I will touch on some of these in this report; while others will be addressed in subsequent reports.


Source: Charles Schwab.