We're Dangerously Close to a Major 'Get Out' Warning for Stocks

The Weekend Edition is pulled from the daily Stansberry Digest.

We've been warning that the U.S. could be inching closer to a full-blown "trade war" with China...

The White House rolled out new 25% tariffs on up to $50 billion of Chinese imports last week. China immediately responded in kind.

President Donald Trump had promised to respond to any retaliation with further tariffs on hundreds of billions of dollars' worth of additional Chinese imports. And earlier this week, he did just that. As the Wall Street Journal reported...

The White House said it would assess 10% tariffs on a further $200 billion in Chinese goods, deepening the dispute with Beijing, while sending a message to other trading partners that the U.S. won't back away from trade fights...

The new tariffs hit a multitude of products including consumer goods, which could produce a reaction against the trade fight. The consumer products include tuna, salmon and other fish, luggage, tires, dog leashes, handbags, baseball gloves, furniture, apparel, mattresses, electric lamps and television cameras and well as components in telephones and flat panel displays.

The administration has tried to limit the impact on consumers, but the scale of the imports subject to tariffs makes that next to impossible.

To no one's surprise, China has once again promised to retaliate. However, its next response won't be further tariffs on U.S. imports, for one simple reason: It doesn't import enough. As the Journal noted in a separate report...

The Trump administration's announcement that it plans to clamp 10% tariffs on a further $200 billion in Chinese goods – from tech gear like routers to furniture and handbags – stoked anger and hand-wringing among Chinese officials on Wednesday.

China doesn't import enough from the U.S. to match Washington dollar for dollar as it has in previous rounds, so Beijing is reviewing plans to hit back in other ways, said Chinese officials familiar with the plans...

A Commerce Ministry statement on Wednesday described Beijing as "shocked" by the U.S. action and said China "has no choice but to take necessary countermeasures."

So what could China do next?

The options range from the relatively benign to the potentially severe. The Journal notes the former includes measures such as blocking licenses for U.S. companies in China, delaying approval of mergers and acquisitions involving U.S. firms, and increasing inspections of U.S. imports at borders.

But if push comes to shove, China has more powerful options at its disposal.

First, it could devalue its currency, the yuan, against the U.S. dollar. Weakening the yuan would make Chinese imports even cheaper, essentially negating the effects of the president's tariffs. But this move could have negative consequences for China as well.

If China were to allow the yuan to fall too far or too quickly, it could cause capital to flee the country. This is exactly what happened in the summer of 2015... And it ultimately helped trigger a sharp correction in both U.S. and Chinese stocks that fall.

In fact, despite the risks, China may already be doing this. The yuan has been quietly falling versus the dollar since April, but the move has been particularly sharp over the past six weeks.

And of course, China still holds more than $1 trillion of U.S. Treasury debt. Under a worst-case scenario, it could choose the "nuclear option" of dumping this debt and potentially crashing the U.S. bond market.

We don't believe this is likely. It would likely hurt China as much as the U.S. But we also wouldn't underestimate how far China might go to "save face" if it believes it has no other options.

Now, it's possible China could reconsider...

It could decide the costs of a trade war are simply too high, and acquiesce to the White House's demands.

We've been critical of the president's high-stakes tactics to date, but we would love to be proven wrong in this case.

However, China appears no more likely to back down than President Trump does at this point. This skirmish could easily escalate from here... And both the U.S. and Chinese economies could suffer as a result.

Trade war or not, we're already seeing some warning signs for the economy and the markets here in the U.S...

We've been keeping a close eye on the U.S. Treasury yield curve. Normally, long-term yields are higher than short-term yields. But occasionally, this relationship changes, and short-term yields rise above long-term yields.

This is called "inversion," and it has historically been one of the most accurate predictors of recessions and major bear markets in stocks.

The most widely followed measure of the yield curve is what's known as the "2-10 spread." As the name implies, this is the difference between the yields of the benchmark 10-year U.S. Treasury notes and two-year U.S. Treasury notes. This spread has been falling nearly nonstop since February, when it peaked at 0.78%.

When we checked in on this measure last month, it had fallen to a new multiyear low of just 0.35%. But it hasn't stopped since, and as you can see in the following chart, it just hit a fresh low this week...


At this rate, this spread could invert (cross zero) before September.

Again, this would be a bad sign for both the economy and stocks...

As you can see, each time the yield curve has inverted, the economy has predictably dipped into recession within the next 12-18 months (indicated by the gray bars).

However, these events have tended to weigh on stocks much sooner. As you can see by the red stars in the chart, the market has peaked within a few months or even weeks of each of the last four inversions.

This is why both Stansberry Research founder Porter Stansberry and our colleague Steve Sjuggerud consider an inverted yield curve a major "get out" warning for stocks.

But this isn't the only early warning signal we're following right now...

Earlier this week, Jim Paulsen – chief strategist at investment firm Leuthold Group – noted that another lesser-known recession indicator is also "flashing yellow" today.

The following chart shows the "Baa" corporate-bond spread. This is the difference between the yield on corporate debt rated "Baa" by ratings agency Moody's Investors Service – the lowest-rated corporate debt that's still considered "investment grade" – and the 10-year U.S. Treasury.

Over the past 50 years, every time this spread has jumped above 2%, a recession has followed within several months (or in the case of the 1990-1991 recession, a recession was already underway). And as you can see, this spread briefly touched exactly 2% last month before pulling back...


To be clear, neither of these signals is a reason to panic and sell all of your stocks today...

The yield curve hasn't inverted yet. There is no guarantee it will anytime soon, but it likely won't be for at least a couple more months – at the earliest – if it does. Likewise, the "Baa" spread is getting close to crossing above 2%, but it has not yet done so either. And perhaps most important, four out of five of Steve's market "vital signs" remain solidly healthy today.

Until these things change, investors would be wise to give this long bull market the benefit of the doubt. Stay long, but stay "hedged"... And keep an eye on your trailing stops just in case.


Justin Brill

Editor's note: While the mainstream media focuses on a potential trade war with China and when the bull market will eventually run out of gas, Porter is worried about something far more dangerous. He says the result of the next presidential election "will send our nation into the worst financial crisis in history, creating a nightmare for Baby Boomers."

Fortunately, you don't have to be a victim. That's why Porter just published a brand-new book, The Battle for America, to guide you through these unprecedented times. Get your copy here.