The U.S.-China trade narrative has gone from simple to complex. That increases the risk to future stock market gains. There are multiple factors intertwining here that muddy the picture:

  • As of the March 20 close, the S&P 500 had risen nearly 13% for its best yearly kick-off since 1998. The size of the early rally means a lot of gains and optimism are already “priced in.”
  • Original U.S.-China expectations were for a clean deal — the $360 billion worth of tariffs would be lifted on both sides, with clear and simple deal terms. Now the odds have increased that the tariffs will stay in some form, and the timeline for any deal has been pushed back for months.
  • Investor concern has shifted from trade war fears to global economic weakness. Money manager surveys show “China slowdown” has become the No. 1 worry topic, displacing “trade war,” which topped the list for nine months in a row.
  • In its policy statement on March 20, the Federal Reserve was so dovish it made investors nervous, causing bond yields and bank shares to fall sharply post-announcement. A central bank on pause is bullish for stocks; a U.S. economy so fragile that the Fed is afraid, not so much.

Let’s dive into each of those points with a little more detail.

If you recall a few months back, 2018 finished out with the worst December for stocks since the Great Depression.

That awful December performance was blamed on Jay Powell, the Chairman of the Federal Reserve, for raising interest rates and speaking too hawkishly, in a way that threatened to kill a fragile U.S. recovery.

In January, however, the Fed executed a radical U-turn. Powell spoke very dovishly, all but apologizing for the earlier hawkishness and rate hike, and stocks rallied sharply. Powell then went on a kind of public apology tour, taking the unusual step for a Fed Chairman of being interviewed on 60 Minutes to explain himself as a friend to markets.

The Powell shift fueled the most powerful V-bottom in decades, as investors grew comfortable with the idea of interest rates staying low.

The early V-bottom in stocks was also fueled by optimism around a U.S.-China trade deal. A deal would be beneficial for the leaders of both countries and would also restore corporate profits and invigorate the global economy.

But here is where things get complicated.

In markets, we have to be aware of what is already “priced in,” meaning the level of good news or bad news that is already reflected in market price movements. After a nearly 13% run-up for the S&P 500 — the best early start in more than 20 years — a lot of market optimism is already baked into the cake.

And the simple narrative of the U.S.-China trade deal — the fact that both sides need an agreement, with tariffs on both sides being lifted — has grown muddy and complex, as the negotiations get dragged out further and the deal terms become unclear.

The $360 billion worth of tariffs that have been in place since the summer of 2018 are an economic drag for both China and the U.S. A new report commissioned by the U.S. Chamber of Commerce estimated that, if the existing tariffs stay in place, American Gross Domestic Product (GDP) could be reduced by $1 trillion over the next decade.

Many people assumed that all tariffs would be lifted in the event of a deal. But now the White House has floated the strong possibility of the tariffs staying in place — even if a deal goes through — until China meets some new and unknown set of rules proving they are in compliance with White House terms.

This change is comparable to starting with a straightforward legal contract, to be executed in one fell swoop, and turning it into a complicated legal contract that executes in phases over a long period. It is hard to tell exactly what the new terms could mean.

It’s clear, though, that the odds of a U.S.-China deal are now reduced (though still more likely than not), because it’s not clear China will accept a continuation of tariffs. It’s also clear a finalized deal will not be as bullish an event as investors first assumed. That, in turn, increases the odds that the 13% run-up in the S&P has priced in a majority, if not all, of the bullish impact of a deal coming to fruition.

Then, too, investor concerns have shifted. A new Bank of America Merrill Lynch survey shows that, for the first time in almost two years, “China slowdown” is money managers’ biggest concern. That is a big change. Prior to this survey, trade war fears had topped the worry list for nine months in a row.

There is ample evidence that China’s economy is contracting, with various data points and forecasts coming in at the weakest levels since the 1990s. At Beijing City Lab, a research arm of China’s Tsinghua University, a multi-year satellite imagery study shows that almost a third of Chinese cities are shrinking.

China slowdown fears feed narratives of global economic weakness. Because of its voracious appetite for raw materials, China has been an engine of growth for emerging markets, and China remains an important market for the U.S., Europe, and Japan. (Apple has a lot of China exposure, for example.) An economic downturn in China would have ripple effects everywhere.

There is also rising concern about what’s happening in Europe. Earlier this month, the European Central Bank (ECB) sounded the slowdown alarm with a renewal of stimulus loans to European banks. Italy is already in recession, Germany is vulnerable, and the risk of a “No Deal Brexit” is playing out to the final buzzer.

As if all the above weren’t enough, the U.S. Federal Reserve has made investors worried.

A dovish Federal Reserve is generally bullish for stocks. That is because stocks benefit from low interest rates and loose monetary policy. When the Fed is dovish and interest rates stay low instead of rising, stock market investors have reason to be cheerful. But if the Fed is dovish because the U.S. economy is headed for real trouble, that is a different story.

After their latest policy meeting on March 20, the Federal Reserve sounded so dovish that investors began to wonder if the U.S. economy is weaker than appearances suggest.

Just a few months ago, there were expectations of two or more interest rate hikes in 2019. The pendulum has now swung so much that, not only have hike expectations disappeared, the markets see a 50% chance of a cut — another drop in interest rates — before the end of the year.

China and Europe are already in slowdown mode, with the weakness threatening to spill over into other regions. If the U.S. slows down too, stock markets around the world would be hit. This is an increasing worry now, with long-term interest rates falling in anticipation.

In sum, the odds of a U.S.-China trade deal are still favorable.

But the odds of a deal have fallen due to political complications, and the likelihood that gains have already been “priced in” is higher. Meanwhile worrisome data points out of China, coupled with a Federal Reserve far more dovish than expected, have combined to heighten investor concerns.

The net result of all this is modestly negative for equities — but mainly in relation to the fact that equities have already rallied a lot this year. Stocks can still move higher, but hopes of a rip-roaring rally on a finalized U.S.-China deal have now fizzled.

Who are the winners here? On balance, these developments are bullish for treasury bonds and gold and gold stocks. We have already described why gold stocks look very attractive in 2019. After the latest round of events, they look even more attractive.

With central banks around the world in retreat — and possibly in “return to emergency stimulus” mode — it could be only a matter of time before fiat currency weakness concerns return to the fore (which would be a strong positive for gold stocks).

As for the U.S.-China trade narrative, though, investors are starting to move on.