Stocks continued a sharp 3-day rally as prospects for renewed trade talks with China continue to improve.

Bonds fell and interest rates rose, slowing the recent tailspin in rates.

It is always nice to see a sharp rally given that most of us are long-only equity investors. But we have ridden this roller coaster too often to get too comfortable that talks will turn into a substantive agreement. We have seen President Trump call Chinese President Xi an outstanding man, we have heard him talk of how well trade talks were going, and we have heard him extol the virtues of the American positions on trade balances, forced technology transfers, and intellectual property theft that only he could tackle and solve. We have also heard him accuse the Chinese of reneging on agreements, mistreating American companies, and being our economic enemy. His feelings today could change 180 degrees tomorrow.

Here is the reality of the moment. We have five separate lists of tariffs on Chinese goods — List 1, List 2, List 3, List 4A, and List 4B. As of this past weekend, we have levied tariffs to various degrees against products on the first 4 lists. Small additional tariffs are scheduled for Lists 1, 2, and 3 on October 1. We expect all those to happen. Lists 1 and 2 covered less than $40 billion of goods. List 3 ratcheted that up, placing tariffs on an additional $170 billion of goods. The September 1 action increased tariffs on all List 1-3 goods and started a new level of tariffs on List 4A of another $125 billion in goods. But the biggie is yet to come. That is List 4B. That includes mostly consumer items from golf shirts to iPhones. What is so key about those tariffs is that over 85% of the goods subject to List 4B tariffs are solely sourced from China. For all the other goods, the percentage was below 25%. There have been alternative options. In other words, if List 4B tariffs are implemented on December 15, as President Trump has announced, both China and the U.S. will be impacted in ways much more significant than the tariffs on Lists 1-4A.

This all may sound like mumbo jumbo but its economic impact is real. China knows it. So does Donald Trump. Neither side really wants to see those tariffs implemented. Trump is running for reelection. Xi presides over an economy losing steam and has his hands full with the Hong Kong situation. The problem is how to come to a solution that both sides can live with. There is virtually no chance of a comprehensive agreement between now and December 15. For one, too much bad blood has been spilled. The Chinese are not used to the verbal abuse Mr. Trump dishes out, they don’t like the tariffs already in place, and they don’t appear ready to make major structural changes. Mr. Trump likes the tariffs, believing they give him leverage and provide the government some income. He wants China to help narrow the balance of payment deficits we have with that country. Several times, he has spoken of Chinese commitments to buy huge amounts of our agricultural products only to find out later that they didn’t come through. Mr. Trump wants to keep tariffs in place to ensure Chinese compliance with whatever agreements are reached. The Chinese want assurances that Trump won’t raise tariffs in the future, as he has threatened to do against Mexico to slow the flow of migrants into the U.S. It won’t be easy.

But trade agreements are never easy. Implementing List 4B tariffs would clearly impact U.S. GDP growth that is already slowing, could raise consumer prices of some high-profile items, and would certainly squeeze corporate profits. You can be almost certain that if List 4B tariffs are implemented as announced on December 15, the stock market will be traded at or above where it is today. Investors are betting that the President will find some way to postpone or cancel those tariffs as the calendar turns to 2020 and the Presidential election. There should be little doubt that Americans will not like the economic pain associated with tariffs if there are no substantive concessions from the Chinese.

The most probable outcome is for low level talks to begin soon, higher level talks to happen in October, and then Trump and Xi will find some way to make nice and come to an interim deal when they meet at the APEC summit in mid-November. Such an agreement might include agricultural purchases that are implemented before the December 15th deadline, making a modest rollback in tariffs, allowing the WTO to reclassify China as a developed nation, and some vague language talking about future measures involving intellectual property rights.

While that is the most probable path, there is plenty of room to derail. If both sides draw red lines that never intersect, compromise may not be possible. Both sides have histories of reneging on promises. Whatever deal Trump agrees to, he will be praised by his acolytes and damned by the liberals. How he reacts to the crosscurrent can’t be predicted.

The bottom line is that the news that both sides are willing to enter substantive talks again is a positive sign, but it is only a first step. Don’t expect any real headway to be made until just before Trump and Xi meet in November. Between now and then, there will be two FOMC meetings and third quarter earnings. While a 25-basis point rate cut in September is now a virtual certainty, October’s actions remain an open question. As for earnings, they should be OK but with an asterisk. The asterisk pertains to forward looking commentary by managements. Anyone affected by List 4B tariffs, and there will be many, will couch any comments with lots of warnings of diminished expectations should those tariffs be implemented.

The other big news item today is the August employment report. 130,000 new jobs were added. But private sector employment rose by only 96,000. The balance was a healthy jump in government workers, which might include an increase related to the 2020 census. The unemployment rate was steady at 3.7%. Average wages were up 3.2% versus a year ago, but over 4.5% month-over-month. For all those worried about deflation, rising wages are offsetting pressure. As noted previously, while segments of our economy, especially those tied to commodities, are experiencing deflation, labor intensive businesses, mostly service oriented, continue to raise prices to offset wage increases. Employers continue to complain of the difficulty of finding people to hire. That, undoubtedly, serves to slow the growth in employment and puts upward pressure on wages.

The bottom line is that, to date, there are no signs that weakness in manufacturing or capital spending is spilling over to the rest of the economy. We are not on the brink of recession. But with that said, cost pressures from higher wages, tariffs, and a strong dollar are likely to limit profit growth from the foreseeable future. So far, none of those pressures are abating. Assuming corporate revenues approximate nominal GDP growth at about 4%, only a slight decrease in margins will turn profit growth from positive to negative. This year’s advancing stock market is all about a recovery from last year’s terrible fourth quarter, and the impact of lower interest rates. For a bull market to endure, eventually, profits have to start rising again. The stock market today is essentially where it was in January 2018. The sectors that have done the best — utilities, real estate, and consumer staples — are the primary beneficiaries of lower rates. Without deflation or sharply lower interest rates, for the bull market to be sustained, eventually leadership will have to rotate. How that plays out will be the story of 2020.

Today, Chris Christie is 57. Pink Floyd’s Roger Waters turns 76.

James M. Meyer, CFA 610-260-2220

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