When we see sharp draw downs in the stock market like we have over the past couple of days, it’s natural to worry it might be the start of something much worse. Indeed, it could be. Odds are, however, that this will be a brief pullback followed by a rebound.
We've been here before
We have seen pullbacks like this before, notably at the end of last year. Back then, markets dropped sharply on signs of slowing economic growth, worries about corporate earnings, and rising political risks, only to rebound as those trends reversed. In significant ways, the past two days are just a repeat of what we saw then.
We can’t always point to a cause for a stock market pullback. Here, we can: President Trump’s tweeted threats to raise tariffs on China by the end of the week. With the market expecting a China deal, the news that a deal was potentially off—and that the situation might get worse—had a real effect on confidence and visibly rocked markets.
By diagnosing the cause, however, we also can see how the situation could resolve. A deal remains likely. It is also quite possible that the tweets were intended as a negotiating tactic, just as we have seen before. If so, and a deal does get back on track, the damage could be reversed quickly (again, just as we have seen before).
Fundamentals remain solid
Right now, the economic fundamentals are more supportive than they have been in recent months. Job growth was great last month, while consumer confidence and spending have rebounded in a significant way. Although business confidence has pulled back, it remains at expansionary levels. Finally, corporate earnings are coming in much better than expected. In other words, during the last pullback, conditions were weakening. Now? They are improving. Solid fundamentals could provide the cushion for a confidence-based bounce back, if a deal is reached.
In the end, confidence drives markets. So, while threats to a trade deal have hit the market, with a solid economic foundation, confidence and markets are likely to bounce once the politics have been resolved.
What's the big picture?
It’s also important to keep the damage in perspective. We have had two bad days after four months in a row of solid gains. As of the close yesterday, the S&P 500 was just over 2 percent below all-time highs, or back at levels of only one month ago. As crashes go, this doesn’t even qualify as a fender bender.
None of this is to say the volatility is over. Now that markets are worried about the trade deal, expect them to react to all the twists and turns. As with any negotiation, especially near the end, we will certainly see both sides dialing up the drama to try to get an edge. We could also see quite a bit more reaction from the markets before a deal eventually gets done. This turbulence is, in fact, normal. Once we have a deal, however, we can expect to see confidence return, as we have before.
One final question
What if a deal isn’t reached and tariffs go up? In that case, we might see more market fallout. Again, that would be due more to confidence than to real economic damage. There will certainly be some economic effect here in the U.S., if tariffs go up as promised. When you actually look at the numbers, however, that damage is likely to be relatively small and easily accommodated at current levels of growth.
In that sense, the current market reaction looks fairly rational. So, the prospect for further damage, while real, is not necessarily substantial, even if we don’t get a deal.
All together now, one more time: keep calm and carry on.