Markets closed mixed on Friday in rather quiet trading. Over the weekend, there was little in the way of new news.

This morning, President Trump came out with a harsh threatening tweet against Iran but, given his past history including his fire and fury threats last winter against North Korea, we have all learned not to take the tweets too literally. Perhaps the real intent of the Iranian tweet this morning is to bring both sides to some sort of negotiation. But at least for the moment, markets are not reacting.

This week 160 members of the S&P 500 will report earnings. Monday mornings and Friday afternoons are generally light reporting times so most of the releases will be packed into a timeframe beginning this afternoon.

The pattern to date has been a good one. Q2 advanced GDP numbers will come out on Friday and the expectation is that growth may have reached 4% in the quarter spurred by tax cuts, deregulation and expansive fiscal spending. Most economists do not believe growth that fast is sustainable. The Federal fiscal year ends in September and it would be unreasonable to expect spending to accelerate at a similar rate next year without an offsetting revenue source (i.e. taxes) given that budget deficits now look like they will average over $1 trillion per year for at least three years. Mr. Trump, as a businessman, was never scared of debt and frequently used the bankruptcy courts, if necessary, to his advantage. But that same behavior isn’t applicable to national budgets. There is no bankruptcy court and the alternatives, from austerity to devaluation, are not very attractive alternatives. Mr. Trump claims he wants to put a lid on future spending. If you remember, he threatened to veto last year’s authorization at the last minute. But with Trump always remember to watch the actions and not listen too literally to what he says. While espousing fiscal conservatism, the President wants to build a wall, build up our military and subsidized industries hurt by the tariffs he is imposing all while staying clear of any entitlement reform. Cutting entitlements may be consistent with fiscal conservatism but it is inconsistent with political populism. Reducing any entitlements, except maybe some relatively small programs like food stamps, will not play well with his base.

While Q2 earnings have been excellent so far and there is little reason to expect any real overall change as the rest of earnings come in, the specter of ever increasing tariffs is a concern. So far, it hasn’t been a concern to markets. The consensus conclusion, similar to what I noted above relative to Trump’s harsh initial rhetoric against Iran and North Korea, is that all will end well with negotiations replacing tariffs as summer wanes and fall approaches. And maybe that is just what will happen. But the stock market, now within just a couple of percentage points of its all time high, seems to be pricing in the positive already. Not only are equity prices high but volatility has returned to pre-January lows once again. Said simply, markets are complacent. One has to ask whether that is the right outcome or not.

Let’s start with Europe. The G-20 meeting of finance ministers is taking place now and, so far, there hasn’t been much change in attitude. U.S. Treasury Secretary Mnuchin says we want to be everyone’s friend, espouses free trade, and simply wants the U.S. to be treated fairly. The words sound good but no one is budging. European leaders have talked of reducing the 10% tariff they place on American autos and that might allow room for negotiations. Germany’s finance minister will be in the U.S. later this week and perhaps the 2

door can open a bit. Trump also talks about the possibility of unilateral talks with Mexico. As for China, the big elephant in the tariff room, the Chinese understand that movement has to happen on their part but, to date, President Xi has stood his ground. Image is important to the Chinese and he doesn’t want to be the first to waiver, perhaps at any cost. It isn’t clear just what it will take for Xi to budge but, for now, the rational expectation is that there is at least a 50-50 chance that additional tariffs between China and the U.S. will be put into place this fall beyond the next $16 billion already set for the end of July.

Many note that we all should put this tariff battle into perspective. If one adds the Chinese tariffs already put into place including the $16 billion coming in another 10 days to the steel and aluminum tariffs, the total only affects about $100 billion of goods on the surface. Given that foreign countries have matched these, you can double that number. But placing an average 10% tariff on $200 billion of goods against a $1.85 trillion GDP and you get a net impact, annualized of only 1%.

But that hardly tells the whole tale. First, the impact of the tariffs fall unevenly. Some companies feel no impact at all while others, like Harley Davidson, are directly targeted. Second, the tariffs raise prices and force changes in buying patterns. If China puts a big tariff on American soybeans or pork, its consumers will try to buy as much as they can away from the U.S. That serves to reduce pork and soybean prices here. If your dinner tonight is going to be edamame and pork chops, you will save some money. If you are a farmer producing soybeans, you are a big loser.

In sum, all the moving parts and unintended consequence are likely to create a bit more havoc than many presume. Whatever further tariffs we implement, the counterparties are going to seek to inflict offsetting pain. Supply chains are going to be disrupted. We can all understand the President’s intentions to improve our relative trade positions worldwide but none of us really know how the saga is going to play out between now and the time everyone sits down and negotiates the deal. Mr. Trump obviously prides himself on his negotiating skills and wants to bargain from strength. Given our size and the fact that we are usually the number one customer around the world, it would appear that we have the ability to inflict more pain than we receive. But that doesn’t insure a quick fight with an obvious pro-U.S. ending. If I can use a boxing analogy, the President might see himself as a Mike Tyson aiming for a quick knockout but he may be in the ring with one of those thugs with an iron chin that will hang around for the full 10-rounds. He doesn’t know and neither do we. What we do know is that a 10-round slugfest usually leaves both sides a bit beaten up.

As investors, that leads to two conclusions. First, with stocks near record highs and valuations once again on the rich side of normal, this is probably not the time to be overly aggressive. In fact, I might consider taking some pops in stock prices related to strong Q2 earnings as an opportunity to raise some cash. Second, in an elongated tariff war that could well stretch into 2019, it might be smart to move money from companies that will be most damaged into others that won’t be as impacted. Tariff wars may not last too long but we could still be early in the battle and there is more blood to come.

Last week, Mr. Trump took a lot of heat for his performance at the Russian Summit as well as his harsh treatment of allies at the NATO meeting. By week’s end, he was doubling down offering to host Mr. Putin in Washington and still tweeting nasty things about Germany. His motto has always been to hit back harder. Remember that as the trade battle continues.

Today, Daniel Radcliffe is 29. Monica Lewinsky is 45. Woody Harrelson turns 57. 3

James M. Meyer, CFA 610-260-2220

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