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This week will decide whether Goldilocks rally has run its course
THE US-China trade deal is in jeopardy, and with it the "Goldilocks" stock rally.
US stocks plunged last week and the broad Standard & Poor's 500 had its biggest weekly loss this year as the unexpected unravelling of the trade deal between Washington and Beijing threatened to cause an all-out economic war.
The trade deal was supposed to complete the Goldilocks scenario that had spurred stocks all year and brought major indexes to new record highs.
Solid US economic data, muted inflation and a change in tone from the Federal Reserve had created the impression of an economy that was neither too hot nor too cold.
A trade war could destroy each leg of Goldilocks' stool. US economic growth could slow as exporters suffer, with economists at UBS already reducing their outlook for GDP growth.
Inflation could pick up as steel makers and semiconductor companies pass the tariff costs down the economic food chain to consumers. Higher inflation could cause the Fed to return to its rate-hiking plans.
The sell-off began when US President Donald Trump unexpectedly responded to backtracking from Chinese negotiators by increasing tariff levels on US$200 billion of Chinese imports.
Just a week earlier, strategists had predicted that most, if not all tariffs imposed during a yearlong trade war would be lifted. Now, the US has threatened to extend the levies to all Chinese imports if concessions are not made in a month.
It's unclear whether either side is willing to pull back from the brink this time. China has not yet specified its response to the latest round of tariffs, which could suggest an appetite for a deal.
But it is difficult to see how President Xi Jinping could compromise while saving face with the Chinese people. He has a range of asymmetric weapons at his disposal, including a wholesale dumping of US Treasuries.
"With talks breaking down, the Chinese government announcing retaliation, and Trump calling for additional tariffs, negotiations will be difficult to restart and nearly impossible if Trump moves forward with the next tranche of tariffs," said analysts at Swiss bank UBS.
"Nonetheless, we continue to assume that further escalation will be avoided; risks around that outlook are obvious."
Strategists at brokerage Bank of America (BofA) Merrill Lynch Global Research said it will take more market "pain" to drive either side back to the negotiating table.
With stock markets and economic data recently strengthening in both countries, there's little penalty to pay for Mr Xi and Mr Trump to take the tough stances that are popular with their home audience.
"Little wonder China is trying to back track and the Trump Administration is reacting strongly," said the BofA analysts. "Moreover, with the S&P 500 down only 2.5 per cent since the tariff tweet, following through on the threat makes sense as well."
There was some consolation for the bulls last Friday. After optimistic comments from Mr Trump and Treasury Secretary Steven Mnuchin, the Dow Jones Industrial Average finished in the green. The spike in the Chicago Board Options Exchange volatility index was all but erased that day.
The "VIX" - or "fear gauge," as that measure is known - reflects the premiums people are willing to pay to hedge against future declines in the stock market.
Investors seemed relieved that the latest episode of brinksmanship was out of the way, and that they could put the issue on the backburner - for a couple of weeks at least.
In the short term, focus is likely to shift to more tangible issues like this week's industrial-production and retail sales data.
Jobs growth appears to have heated up, if anything, in recent months. But other data hint that the housing market, among other things, is cooling down.
If the Goldilocks mood from the first four months of the year is to return to the stock market, the readings of factory activity and retail sales will have to confirm that the economy is still at the ideal temperature. A strong earnings report from Walmart would also lift spirits.
"Everything of course is overshadowed by trade negotiations," said Joe Kinahan, chief market strategist at brokerage TD Ameritrade.
"Earnings season so far has been pretty good on lower expectations of course. What I've been happy to see is it hasn't been CEOs throwing their hands up about China; it hasn't been CEOs throwing their hands up about stronger dollar. It's actually been a fairly optimistic earnings season."
The deal market is less optimistic. The long-awaited initial-public offering of Uber Technologies was one of the biggest flops among recent stock-market debuts.
Shares of the ride-hailing service fell almost 8 per cent on their first session.
Some strategists say the poor stock-market reception for Uber and smaller peer Lyft suggests that many startup "Unicorns" - those with over US$1 billion in value - are overpriced, a bubble created by venture capital sloshing around Silicon Valley. If this is the case, there could be more selloffs in store for Airbnb and others.
This week will decide whether the interruption in the Goldilocks rally is temporary or a full-scale correction.