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Markets Roil on Yuan Devaluation

Jeff Remsburg

China just upped trade war tensions. What to know, and what to do about it

Yesterday marked the worst percentage drop of the entire year for all three major U.S. stock indexes.

The Dow plunged more than 900 points at its low, closing 767 points down. Meanwhile the S&P dropped 3% while the Nasdaq shed 3.5%.

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As I write Tuesday afternoon, markets are regaining footing as China’s central bank signaled it wouldn’t allow the yuan to fall much further.

This latest volatility comes courtesy of the escalating trade war. Last week, Trump said the U.S. would place a 10% tariff on the remaining $300 billion of Chinese goods beginning Sept. 1. In response, yesterday we learned that China has asked state-owned companies to suspend U.S. agricultural imports. But more importantly, Beijing allowed its currency, the yuan, to sink to worse than seven per U.S. dollar yesterday — that’s its weakest level in over a decade.

Source: WSJ

A weaker yuan makes Chinese goods cheaper for overseas buyers, which is Beijing’s attempt to cushion the blow from Trump’s tariffs.

Much of the fear yesterday was that China’s unwillingness to protect the yuan’s psychologically-important level of 7 meant they’d largely given up on hopes of a trade deal with the U.S. And if there was no meaningful trade deal, investors fear we’re headed toward a real economic slowdown, both in the U.S. and globally.

Fortunately, today’s news that the Chinese central bank will stabilize the yuan offers some hope — though it hardly means we’ve seen the end of volatility.

***Yesterday, a widely watched Treasury-market recession indicator — the yield curve inversion — hit its highest level since 2007

Yesterday, scared investors fled to safety, pushing down bond yields.

The 10-year Treasury fell to 1.74%. At one point, the yield was 32 basis points less than the three-month bills — in other words, “inverted.” Many investors believe such inversions signal a coming recession.

Yesterday’s inversion was the most extreme we’ve seen since just before the 2008 crisis.

Based, in part, on this news, the CBOE Volatility Index, also known as the market’s “fear gauge,” surged 36%. And gold, historically a safe-haven investment, saw a 1.3% gain.

As I write Tuesday morning, the 10-year yield has edged up slightly to 1.758%.

***Given this market volatility, let’s turn to John Jagerson of Strategic Trader for some insight into what’s happening, and what to expect next

Jeff: As you look at the most recent trade war issues, what jumps out at you as most significant and what investors really should be watching?

John: Traders have so far been willing to give the trade war the benefit of the doubt that it can and will be resolved soon. Eventually, that patience will wear too thin to sustain prices at the current level.

I don’t know if this round is the final straw or not, but it’s getting closer. I also have to add that the Chinese government targeting agricultural imports from the U.S. (although they have denied this) is an important escalation because it means they are taking action with the apparent intent to affect President Trump’s reelection chances.

Jeff: To what degree is this a major development that will impact markets over several quarters, versus a short-term, high-volatility event that will fade in importance within weeks?

John: I don’t see this as the “end” of the current rally at this point. However, I have to admit it increases the odds of a bear market in the short-term. If prices break the neckline of the head and shoulder pattern that emerged earlier this year (around 2800 on the S&P 500) I would expect a much more significant decline.

The biggest issue for the U.S. economy is the threat of rising consumer prices as tariffs increase the costs of imported goods. This is bad timing as the 3rd and 4th quarter shopping season are so important to overall economic health and confidence in the U.S. A healthy U.S. consumer has saved the market this year and this escalation threatens consumer spending trends.

Jeff: If we hold the neckline you just referenced, when do you expect we’ll see the U.S. stock markets reverse and continue higher?

John: Statistically speaking, as long as growth remains positive (which it currently is) then declines rarely last longer than 30 days. This week is likely to be bad, but I don’t see any reason yet to assume we won’t see a rebound to prior highs within 30-days. However, I think breaking to NEW highs may take much longer.

Jeff: Do you believe this increases the chances we’ll see additional rate cuts this year?

John: If the tariff war starts to further affect actual economic growth then I believe we will see the Fed cut the overnight rate this year as a way to boost confidence, but I don’t know that it would do much to offset the damage from the trade war.

The Fed cuts rates to increase the supply of capital. The U.S. banking system could be swimming in money from the Fed but they can’t be forced to lend and invest.

It also won’t change the fact that consumers are paying higher prices for imported goods and U.S. exporters are suffering from reciprocal tariffs and reduced international demand. In fact, if the Fed cuts rates too aggressively it may increase inflation rates and hurt consumers further.

Jeff: One of the bigger red flags coming out of yesterday was the yield curve inversion. How are you viewing this?

John: This is a tough issue. An inverted yield curve has been a good long-term indicator of recession in the past. I see no reason why “this time will be different.” However, the timing of this signal is tricky.

It can take more than a year, during which the market continues to rise, before a recession starts, so I think investors should refrain from making too many bearish plans before 2020. That was what happened before the financial crisis in 2008.

An inverted yield curve makes lending much less profitable because the banks are borrowing at short-term rates that are either higher or nominally lower than their long-term lending rates. In this situation, credit conditions tighten which can reduce growth very quickly because capital is less available.

If Investors continue to move into bonds as a safe-haven during the trade-war, it will accelerate the yield curve’s inversion and the risk of recession in 2020 will rise dramatically.

Jeff: Wrapping up, what’s your quick advice to traders, and then your advice to long-term investors?

John: For traders, short stocks with poor fundamental trends. Exit at prior lows. For long-term investors, if the S&P 500 starts to rise off support at 2800, I would recommend adding large caps with strong positive fundamental trends to a portfolio.

Jeff: Thanks, John.

With the S&P currently at 2870 and rising as I write, it appears we’re not in any immediate danger of breaching the key level of 2800 John referenced. We’ll be looking for more signs of a sustained rebound over the coming days.

***Meanwhile, Louis Navallier sees a big reason why he expects the market will rally — the S&P dividend yield

Yesterday, Louis held a special podcast for his Accelerated Profits subscribers to discuss the market volatility. In short, he expects a coming market rebound.

From the podcast:

Right now, as I speak to you, the 10-year Treasury is 1.77%… And the S&P’s dividend yield is well over 2%. So, it’s almost 30 basis points difference between the S&P dividend yield and the 10-year Treasury.

Louis then referenced the tax treatment differential between dividends and bonds, and pointed toward what he’s watching now — stock buybacks. This led to his takeaway:

So, you will get a big reversal in the market … Look how great the dividend yields are, and corporate America starts to buy their stock back. So, I’m not worried about the market at all …

We’ll continue to keep you up to speed here in the Digest.

Have a good evening,

Jeff Remsburg

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