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Opinion: Here are the stocks to buy for the coming trade deal rally

MarketWatch logo MarketWatch 5/14/2019 Michael Brush

Editor's note: The opinions in this article are the author’s, as published by our content partner, and do not necessarily represent the views of MSN or Microsoft.

On May 2 we suggested caution on U.S. stocks because sentiment seemed rich, and four risks appeared likely to ding the markets, including a breakdown in U.S.-China trade progress.

Since that cautionary note, that last risk has surfaced in spades. So the S&P 500 Index (SPX) Dow Jones Industrial Average (DJIA) and Nasdaq (COMP) are down 4%-6%. Those indexes are rebounding Tuesday.

Now it is time to get more aggressive about re-deploying any cash you may have raised in early May. The reason: A China trade deal is very likely to get wrapped up over the next few weeks for the following five reasons.

Read:Here are the stocks to buy if an all-out trade war erupts, says Goldman Sachs

1. Trump needs a deal to get re-elected

It’s important stay apolitical to see things clearly in market analysis. So don’t paint me as a “Trump hater” when I say the following: President Donald Trump hasn’t accomplished a heck of a lot as president. Among his few meaningful, and obviously major, victories are: 1. keeping the Obama recovery alive; and 2. helping to boost the wealth of lots of voters by inspiring a continued stock market rally.

We know these are two of Trump’s top wins, because they come first whenever he cites accomplishments in campaign rallies. To give Trump his due, meaningful deregulation has contributed to economic and market strength, and that’s something that’s different from the Obama era.

But since sustained market gains and economic growth are among his few victories, they are fundamental to his 2020 re-election bid. Trump knows this. So he and his team have plenty motivation to get a China trade deal done.

The current trade-related market weakness “reminds us of the market vs. the Fed in December,” says Larry McDonald, of the Bear Traps Report. “In our view, the beast in the market will continue to push Trump until he has to capitulate on key issues and make a deal.”

There are the big risks that Trump and Chinese President Xi Jinping know they need to avoid. So they will hammer out a trade deal and avoid higher tariffs and trade wars.

Related video: How will the market react to Trump's trade battle with China? (provided by USA Today)

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2. Tariffs could spark inflation in the U.S.

U.S. inflation has been remarkably tame in this recovery, despite the tight labor market. This matters to investors because limited inflation makes for a happy Federal Reserve, or one less likely to impose stock- and bond-killing interest-rate increases.

So far, personal consumption expenditures (PCE), the Fed’s preferred inflation measure, has stayed in check. But this could change because of tariffs. Trump likes to give the impression that tariffs come out of the pockets of the Chinese. But in reality, either U.S. consumers pay in the form of higher prices, or companies take the hit if raising prices on their goods threatens sales growth.

As economists at Goldman Sachs point out, prices on goods impacted by tariffs have been rising considerably since early 2018, when the U.S started imposing tariffs. So far, this hasn’t pushed overall inflation into the danger zone. But even more tariffs would move prices in that direction.

a close up of a map© Wall Street Journal3. Inflation risk could remove the ‘Fed put’

One of the main reasons the huge market decline last year reversed was the assurance by the Fed that it would back off on rate increases, and that it might even cut rates. Known as the “Fed put,” because owning put options protects against downside losses in the market, this assurance calmed investor fears.

Though Trump can’t influence the Fed directly, the “Fed put” was Trump’s ace in the hole for supporting the stock market — to improve his election odds. Higher inflation caused by more tariffs threatens to take away the Fed put, points out McDonald. Trump and his advisers know this. So they feel pressure to strike a deal to preserve the Fed put.

4. Trade wars could hurt the U.S. economy

U.S. exports to China represent a minuscule 0.6% of gross domestic product (GDP), says McDonald. So Chinese tariffs on U.S. goods don’t seem like a big deal for the U.S. But in reality, tariffs could have an outsized impact on the U.S. economy by dampening business confidence. Trade wars hurt global growth, and business leaders know it.

This would hit business spending at a time when growth is already pretty weak. (Much of the 3.2% first-quarter GDP growth was due to the one-off of inventory building ahead of expected trade wars.)

While business confidence has been hanging in there, we are already seeing some signs of a decline. Commercial and industrial loan growth slowed a bit in April, for example.

“The big issue is how much does this hit confidence,” says James Paulsen, chief investment strategist at the Leuthold Group. “That is what I worry about. If you shut down private-sector behavior, that would be bad. And these things can do that.”

Steeper stock market declines from here would also weigh on business and consumer confidence.

The good news is that last year’s market slide and economic worries did not kill off business and consumer confidence enough to hurt growth. And despite the length of this recovery, there are few signs of the excesses that normally crop up toward the end of an economic cycle, points out Paulsen. Consumer and corporate balance sheets are generally strong, and so are balance sheets in the financial sector.

5. China’s economic growth is faltering

Trump isn’t the only one feeling the heat. China just threw a ton of stimulus at its economy in the first quarter. So its first-quarter growth seemed to get back on track, at 6.4%. But there are lingering signs of problems, despite all the stimulus. Manufacturing activity dropped unexpectedly last month. Exports fell too.

A trade war could make things a lot worse for China. Exports overall account for around 18% of China’s GDP and U.S. exports make up 3.5% of its GDP, says McDonald. So a trade conflict that hurts growth could force Beijing to ease credit and boost government spending at a time when it should be rolling back stimulus following the first-quarter binge.

The bottom line: Because of all of the pressures listed above, we are likely to see a trade deal soon. “Both sides are worried about the fall out here,” says Paulsen. “If there is any truth at all that they were 90% along, then there is room to announce an agreement where both sides can hold up some victories. This could end as fast as it came.” McDonald, at Bear Traps Report, thinks a deal could happen in the next few weeks.

What to buy?

It makes sense to focus on the groups hit the hardest hit by trade-war fears. Two that stand out are chips and agriculture. Products in these areas are high on the list of items China would further block with tariffs. Consider buying chip sector exchange traded funds (ETFs) for broad exposure, like iShares PHLX Semiconductor (SOXX) VanEck Vectors Semiconductor (SMH) or SPDR S&P Semiconductor (XSD)

Or consider high-quality individual names that are down a lot, such as Intel (INTC) and Nvidia (NVDA)

For agricultural sector exposure, consider iShares MSCI Global Agriculture Producers (VEGI) I also just reiterated the potash and phosphate fertilizer company Mosaic (MOS) in my stock letter, Brush Up on Stocks, in part because of compelling insider buying in the name in the current weakness. The stock is down almost 40% in the past six months.

Manufacturers get hit by trade war fears because of worries about exposure to China and a slowdown in global growth. Two to consider here are Caterpillar (CAT) and Boeing (BA). 

Many biotech names are getting hammered by the China trade-war fears. This makes sense in a way because biotech is a high-beta group. But on the other hand, the biotech weakness makes little sense since sales are linked to demographic and health-sector trends, and not international trade.

Consider Biogen (BIIB) in the current weakness, which I recently reiterated in my stock letter. For investors who want to remove company risk from the equation, consider iShares Nasdaq Biotechnology Index (IBB) and SPDR S&P Biotech (XBI) ETFs.

At the time of publication, Michael Brush had no positions in any stocks mentioned in this column. Brush has suggested INTC, NVDA, MOS, CAT, BA, BIIB, SRPT, IBB and XBI in his stock newsletter, Brush Up on Stocks. Brush is a Manhattan-based financial writer who has covered business for the New York Times and The Economist Group, and he attended Columbia Business School in the Knight-Bagehot program.

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