On the heels of yet another very strong year for stocks, 2018 began with many investors wary of the long rally and seeking an excuse to book some gains. It seemed like a selling impetus materialized just in time in the form of rising interest rates which, as measured by the 10-year Treasury rate, jumped from 2.40% at year-end to as high as 2.94% in February. Stocks struggled with the pace of the increase, and despite the yield backing off to 2.74% by the end of the quarter, the S&P 500 couldn’t advance in Q1. At Peloton, we have argued for some time that the underlying economic fundamentals are strong enough to withstand higher rates and that further normalization of the yield curve is necessary (i.e. Fed hikes and higher market rates). Not everyone agrees, and our stance certainly won’t stop nervous investors from taking short-term action.

The 10-year yield went on to top 3.10% in the second quarter, but stocks managed to rebound with a 3.43% gain, leaving the S&P 500 positive by a couple percent for the year. However, a bona fide fundamental concern arose during Q2 as President Trump ramped up his rhetoric on international trade. The degree to which the administration’s disjointed collection of swipes, jabs, barbs, and threats congeals into reasonable trade policy matters a lot for stocks. Generally, markets operate more efficiently with fewer taxes and barriers, so it’s no surprise that stocks have been hanging on the President’s every word on trade – falling sharply on days when talk is particularly tough. Perhaps most nerve-wracking is the haphazard manner in which policy is being announced. Viewing the media moment when tariffs on steel and aluminum were first floated, one got the impression that the actual percentages were conjured on the spot, mid-sentence.

Clearly if trade tensions morph into a true trade war, that would be bad news for stocks. The question then becomes “how bad?” – and the answer depends on the momentum of the offsetting positive fundamentals: economic strength, wage growth, lower taxes, and corporate profit growth. In the second half of the year, we expect trade talk to continue jolting markets, especially following the President’s recent meetings with President Putin, Kim Gong-un, and of course the peculiar NATO summit.

As we progress through the first year with new tax rules, we’ll see more and more of the positive impacts on corporate and household cash flow. Earnings growth should maintain a brisk growth pace, which is supportive of stocks at current or perhaps higher levels. Higher interest rates become a headwind for the economy (at some point), but the recent move up doesn’t appear to be weighing on the parts of the economy most at risk, like housing. Financials would actually benefit from higher rates but are already posting consistently strong results despite a stubbornly low rates and a relatively flat yield curve. In this environment, the Fed should not waiver from its commitment to incrementally tighter policy. Whether the FOMC raises rates two more times or four more times during this year won’t have long-term implications for stocks.

The mid-term elections will also garner some interest, but we don’t expect a seismic shift in the composition of Congress. The biggest swing factor right now is the evolving trade discussions, specifically whether policy actions by the U.S. and/or trading partners undermine profits that are currently expected to increase 25% this year over last.