Stocks rallied for the fourth straight session yesterday. What differentiates the recent rally is that the Dow Jones Industrials have been leading the S&P 500 and the NASDAQ Composite for the first time in a long while.

Might some rotation be going on? Actually, since May, there has been a bias toward the defensive stocks over the past two months. It is too early to call it a trend but it bears watching. Such a move might also signal that the buyers of the tech high flyers are starting to become a bit concerned over valuation. While some of the stocks that corrected, like the leading semiconductor names, have rallied nicely over the past week, they aren’t setting new highs.

Last night, President Trump appeared to escalate the trade war threatening 10% tariffs on an additional $200 billion of goods coming from China. While futures are lower this morning in response, this really isn’t new news. At various times, the President has threatened tariffs on as much as $400 billion of Chinese imports at rates as high as 25%. The latest foray in the trade war requires a 60-day comment period that would take up to September at the earliest before tariffs can be implemented on an additional $200 billion in goods. Since we export far less than $200 billion to China, it cannot retaliate in kind tit-for-tat. That means China will have to come up with an alternative which could include everything from a boycott of American produced products to a program to sell Treasury securities. What is more like is that as the summer wears on, both countries will resume talks to iron out trade differences. China felt that its offer to buy billions more of American goods, like oil and soybeans would be sufficient but that is far from a complete response. Whether you like Trump’s tactics or not, clearly the trade rules of engagement have been very favorable in China’s direction for years and that doesn’t take into consideration its blatant disregard for intellectual property rights. Essentially, Trump’s message is either negotiate in good faith or bear the consequences of a trade war where China stands to lose more than the U.S.

Trump’s focus this week isn’t just on China. At the NATO meeting, he continues to berate our allies for not spending enough on defense. So far, he hasn’t laid out direct actions we might take if the NATO members don’t cough up enough money but clearly he would not be overly disturbed if NATO disappeared altogether. In his view, NATO needs us much more than we need them. He has consistently favored bilateral agreements over broad scale treaties involving multiple nations. He thinks he can get better terms that way and, because of the United States’ relative size advantage compared to each NATO member nation, he can brow beat virtually everyone into a better deal. That doesn’t mean we won’t have the backs of key NATO nations nor does it mean we won’t be asking for support should be feel the need to undertake military action similar to Iraq and Afghanistan. We could continue to sell weapons and provide military support but on our terms. All this comes in front of his summit with Vladimir Putin next week. Putin must be all smiles as he views a weakened NATO as an opportunity to elevate Russian influence in the region. Perhaps that is why this morning President Trump specifically called out Germany’s agreement to buy gas from Russian as a mistake. As he himself calls Russia a competitor, he probably would prefer to see Germany buy U.S. LNG than Russian gas.

For months, markets have dealt with Trump’s disruptive behavior. What has happened almost always is that the short term negative impact of his verbal threats has been a one session (or less) decline followed by a gradual recovery. I expect the same thing to happen this time around. As I often note, markets are not emotional. They aren’t Republican or Democrat. They don’t care about war, children isolated at the border or how a Supreme Court nominee 2

might treat Rowe v. Wade. They only care about earnings, interest rates and the dollar. So, let’s look very briefly at each.

Earnings: We all know Q2 earnings will be good, probably even better than the expectation of 20%+ growth. Those numbers might be celebrated over the next few weeks. But year-over-year earnings growth probably peaked in Q1 when the dollar was weakest and interest rates were the lowest. Moreover, there are some signs that international growth is no longer accelerating even as U.S. GDP could show a 4%+ tick in the second quarter. We don’t know the impact of the first rounds of tariffs but there are not huge and shouldn’t knock more than a quarter point off of U.S. GDP growth in the third quarter. With that said some specific companies and industries, like farming, will be more impacted. Investors need to react accordingly.

Interest Rates: As for interest rates, the 10-year Treasury has been in a rather narrow range for months. It could rise slightly as inflationary pressures creep up and as demand for debt at the sovereign level increase due to rising Federal deficits. On the other hand, both the ECB and Bank of Japan are keeping a cap on rates until well into 2019 and that will help to restrain any rise in U.S. rates over that period. Thus, while rates may still rise directionally, the pace of increase has slowed and should continue to be slow. That means interest rates will remain a headwind to equity valuations but a small headwind than we witnessed in the first half of the year.

Currency: The dollar has strengthened since early 2018 as our growth rate has accelerated while growth in Europe and Japan has eased a bit. But I don’t see how 4%+ growth can be maintained even allowing for some productivity improvement. The tariffs will be a direct headwind but the associated uncertainty could easily defer certain investment decisions. To the extent that countries around the world import less from the U.S. due to tariffs, they might buy more from countries like Brazil. I think most of the dollar gains are behind us, at least for now.

Thus, the backdrop suggests that we remain within a trading range probably until close to the November elections as investors await the outcome of trade negotiations and the election results. Obviously, the key to elections is which party gets control of the House. If Democrats win, they get to set the agenda. That would insure almost no major legislation until 2020. Even if Republicans retain control, they are likely to lose seats. Unlike a congenial Senate where there are only a handful of outspoken Republicans on the left and right of center, the House has a strong conservative bloc that will almost certainly retain power post-November. Getting major legislation done is never easy and it becomes more complicated in today’s combative times. There could be some compromise on immigration should Republicans retain the House but even that is uncertain. Economically, with the tax cuts behind us and deficits threatening to top $1trillion annually, one shouldn’t expect and significant action that while raise GDP. Thus, no matter who wins, look for nothing meaningful from Congress that would be economically impactful until at least 2021 unless some intervening crisis dictates action sooner.

Thus, despite the political turmoil, there isn’t any reason to expect a major change in course for equities. Expect equities to stay within a trading range until trade and political issues come into clearer focus. At the moment, we are closer to the top of the range than the bottom approaching earnings season. If earnings are much better than expectations, that could provide a lift that could push stocks toward new highs. But remember the stock market is all about expectations, not actual results. 20%+ growth is expected. Simply matching expectations won’t lead to new highs.

Today, Giorgio Armani is 84.

James M. Meyer, CFA 610-260-2220 3

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