This week was again all about the trade war heating up between China and the US as well as internal political tensions as the Senate voted to reinstate the ban on ZTE sales, a clear challenge to President Trump. That led to a spike in CBOE S&P 500 Volatility Index (VIX) futures early in the week with the index up over 20% in the past five trading days as of Thursday’s close.

The Markets

With the exception of the Russell 2000, the major equity market indices have all declined over the past week. On Tuesday the Dow Jones Industrial Average moved into the red for the year and by Thursday’s close was down 1% from the start of the year. Conversely, the small cap Russell 2000 and the Nasdaq Composite were both up over 11% for 2018 as of Thursday’s close, with the S&P 500 lagging well behind at up 2.9%. The Russell 2000 index reached a new high Wednesday. The story here has been tech and a shift towards domestically focused, small cap as the global trade war heats up and the dollar strengthens. The chart below shows just how powerful the tech sector has become with 7 of the 10 biggest stocks in the world tech-based.

If we dig into the details, the underlying market dynamics are very telling. The median stock (ex-tech) is down 5% from the late January peak and down 40 basis points year-to-date. Nearly 70% of the S&P 500 is trading below their late January peaks and around half of the S&P 500 is 10% below their 52-week highs. The S&P 500 has not made a new high in almost 5 months and the forward P/E has compressed from 20x to just over 17x. This suggests to us here at Tematica that confidence in robust earnings expectations is waning as trade war and tariffs escalate.

While the headlines tell us that the economy is booming and expectations for Q2 GDP growth are well over 4%, the bond market isn’t buying it with the 10-year U.S. Treasury yield, (a proxy for longer-term GDP growth expectations) remaining stubbornly below 3% while GDP estimates are being revised up. Talk about a disconnect. Q2 GDP is still looking like it will be pretty solid, but according to FactSet, corporate earnings growth has already peaked.

While the Fed is expecting that it will hike rates four times this year, we are seeing the yield curve continue to flatten as short-term rates rise, but the longer-term rates remain low. The 1-month Treasury bill yield hit a multi-year high this week, bringing the spread between it and the S&P 500 dividend yield down near zero for the first time in 10 years. The spread between the 30-year Treasury yield and the 5-year Treasury yield is down to a level not seen since 2007.