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The Fed's retreat leaves just one big question mark for the stock market

Key Points
  • There were three big question marks heading into 2019: Shutdown, Fed, and China trade talks.
  • The Fed's confirmation that it is pausing its interest rate hikes has sidelined itself.
  • Analysts believe China trade talks will come down to the wire ahead of the March 2 deadline before any deal is struck.
Chinese President Xi Jinping and members of Chinese delegation attend a working dinner with U.S. President Donald Trump after the G20 leaders summit in Buenos Aires, Argentina December 1, 2018. 
Kevin Lemarque | Reuters

Two down, one to go.

There were three big question marks heading into 2019, and now there's just one.

The government shutdown ended last week, and on Wednesday the Federal Reserve was successfully pushed to the sidelines. That leaves just China trade talks as the next big fundamental issue to be solved.

Only five weeks ago, the Fed was seen as a negative force for markets when it raised interest rates and emphasized it could do more hiking this year. But in the face of a market meltdown, Fed officials made it clear they would be flexible and patient on policy, which is just what they emphasized in their post-meeting statement Wednesday.

That leaves the U.S.-China trade discussions as the biggest issue for markets now, though the threat of another government shutdown does remain somewhat.

"The trade policy over the next month is going to matter more. We have some time before the next Fed meeting. They may prune around the edges with Fed speak in the next six weeks, but this is a very clear message," said George Goncalves, head of fixed income strategy at Nomura. "They're offline. It doesn't mean they're necessarily over. But my gut is telling me, it is over and their hurdle to do more tightening is very high."

Chinese economy

Fears the Fed would stall out the economy with too many interest rate hikes snowballed in December, along with worries about trade wars and a slowing Chinese economy. Worries about a recession drove stocks into a tailspin, with selling reaching a crescendo on the day before and morning after Christmas.

The Chinese economy has been weakening though Beijing is using both monetary and fiscal stimulus to try to jump-start it. U.S. companies like Nvidia and Apple have said their revenues have been hurt by softer Chinese sales, and analysts believe there could be a sharp stock market rally if trade issues are resolved.

Luke Tilley, chief economist at Wilmington Trust, said he views the slowing Chinese economy and trade wars as a linked issue for markets.

"Our view is we still have a solid economy. We expect 2.5 percent growth. On the U.S. side of the statement, proposed tariffs and an escalation in tariffs and retaliation between the U.S. and China, those would be material enough to change our view on the U.S. economy and growth going forward," he said. "The resolution of those tariffs are important for the outlook."

Tilley also puts the possibility of another government shutdown and problems around the debt ceiling talks as risks for the markets, though some strategists do not believe President Donald Trump would allow the government to be shut down again both because of public sentiment and the damage to the economy.

Markets have been hoping to see some positive developments from the two days of high level trade talks that started Wednesday between Chinese Vice Premier Liu He and U.S. Trade Representative Robert Lighthizer. The negotiators are working to reach a deal before the March 2 deadline, when the U.S. would raise tariffs on $200 billion of Chinese goods from 10 percent to 25 percent.

"We would assign a low probability to an agreement being reached this week and there is a possibility of some negative news flow should the Chinese not produce sufficient structural reforms to satisfy US Trade Representative Robert Lighthizer," said Dan Clifton, head of policy research at Strategas. He said Lighthizer has been skeptical that China will offer enough structural reforms to prevent tariffs from escalating in March.

China has offered to increase imports of U.S. agriculture, energy and some industrial goods to narrow the trade gap, over a six-year period. The U.S. has been seeking to increase protection of U.S. intellectual property and accuses China of cybertheft. In a sign of deeper friction, the U.S. has filed charged against Chinese telecom company Huawei with bank fraud, wire fraud and stealing state secrets as well as alleging its CFO misled U.S. financial institutions about its dealings with Iran.

"Our sense is that the Chinese offer this week will go a step further by offering specific timelines that ease restrictions on foreign investment and protect intellectual property," Clifton said. "Enforcement mechanisms to ensure compliance are also likely to be included. Missing from these proposals is anything on state-owned enterprises which is why Lighthizer believes tariffs need to continue until the Chinese feel enough pain to make further reforms."

Clifton expects the talks could result in preventing further tariffs but not necessarily result in the removal of current tariffs.

Violent reaction

Chris Rupkey, chief financial economist at MUFG, said if no trade deal is reached, the markets could have an extremely violent reaction, but he suspects that Trump would make sure there's a deal, given his interest in stock prices. Trump, in fact, tweeted that he was pleased to see the Dow at 25,000 Wednesday, after it rallied sharply on the Fed's statement.

"It shows you he has one eye on the election, the other eye on the stock market," Rupkey said. "I think he wants a deal. We've seen this before. He talks tough until the last second. I don't want to say he folds but he gets less than people were thinking he wanted. I think he's going to talk tough."

Trump is scheduled to meet with the Liu on Thursday.

If he fails to strike a deal, and both sides resume their fight, markets surely would react. "We'd go down a couple thousand points on the Dow. It would be bad, very bad. The market would do what it did in December," Rupkey said.

While Rupkey does expect a positive resolution with China, he sees other trade issues as potentially problematic.

"I'm hopeful China will be out of the way. The only thing that worries me and it's going to stretch out for a long time is the risk of putting tariffs on European car exports to this country. That's going to drag on forever," Rupkey said.

Clifton agrees that European tariffs could be an issue, and he said the real trade policy error could be European auto tariffs. "The Commerce Department is expected to release its auto tariff recommendations in mid-February. The EU has refused to include agriculture for US-EU trade negotiations which is raising the prospect that Trump may pull the trigger on auto tariffs," he wrote.

Analysts have said the stock market could continue to trade sideways or sell off, as investors consider earnings releases and headlines on trade. They also believe it could continue to be held back if the government shutdown threat returns. Congress and the White House face a Feb. 15 deadline to come up with an agreement on government funding.

"I believe there's going to be some portion of these tariffs that are permanent. I don't think this is resolved. This is policy," said Jack Ablin, chief investment officer at Cresset Asset Management. "I guess the threat is people aren't viewing it that way. They view it as temporary."