The global trade war is acting like a gigantic eraser, wiping out trillions of dollars in economic activity. Accordingly, Wall Street started the third quarter today with only meager gains, amid choppy trading and mounting investor uncertainty.

New manufacturing data released Monday showed that sputtering export sales and a slowdown in new orders undermined factory growth in June. The Dow Jones Industrial Average,  S&P 500 and tech-heavy Nasdaq all ended in the green today, but stocks spent most of the day in deeply negative territory.

Trading today was volatile, with the Dow down 193 points at its session low. The Dow eked out a slight gain in the final minutes of seesaw trading. The big winner was the Nasdaq, as gains in large-cap tech stocks helped offset pessimism over trade.

IHS Markit’s final manufacturing Purchasing Managers’ Index (PMI) for the European Union declined in May for a sixth consecutive month, falling to an 18-month low of 54.9. Other key PMIs for June, also released today, confirmed evidence of a global economic slowdown. China came in at 51.0 (versus 51.5 in January) and Japan at 53.0 (vs 54.8 in January).

The U.S. was the only bright spot, coming in at 60.2 last month compared to 58.7 in May. However, a granular look at the U.S. data reveals that tariffs already are taking a toll on activity.

Canada’s new tariffs on $12.6 billion worth of U.S. products went into effect Sunday; China’s are scheduled to kick in by Friday.

On Sunday, President Trump said he views his threat to slap tariffs on global auto makers as his biggest weapon to wring concessions from trading partners.

Sunday also brought news that leftist candidate Andrés Manuel López Obrador won the presidency of Mexico in a landslide, furthering complicating already troubled talks to re-negotiate the North American Free Trade Agreement.

News reports surfaced Monday that the White House is drafting plans to abandon the World Trade Organization. The U.S. Chamber of Commerce, typically an ally of the Republican Party, launched a lobbying and media campaign today to oppose Trump’s protectionist policies.

Dangerous curves…

The bond market is a source of worry as well, as the yield curve warns of impending recession.

The yield curve is the difference between interest rates on short-term U.S. government bonds (e.g., two-year Treasury notes) and long-term government bonds (e.g., 10-year Treasury notes).

Historically, when an economy is robust, the rates on longer-term bonds are higher than short-term ones. In part, the additional interest is to compensate for the risk that economic growth could overheat and trigger inflation.

In recent months, though, long-term bonds have risen only sluggishly, suggesting that traders are concerned about long-term growth.

At the same time, the Federal Reserve has been hiking short-term rates, which has caused the yield curve to “flatten,” which means the gap between short-term interest rates and long-term rates is shrinking.

The gap between two-year and 10-year U.S. Treasury notes currently hovers at levels last seen in 2007, when the U.S. economy was on the verge of the worst economic downturn since the Great Depression.

If rates keep moving in this direction, eventually long-term interest rates will fall below short-term rates. That’s when things get scary. An inverted yield curve has been an accurate predictor of recessions.

How accurate? Every recession of the past 60 years has been preceded by an inverted yield curve. See chart (compiled with Bloomberg data):

Coming off the “sugar high”…

Robust projected corporate earnings growth continues to prop up this wobbly market. For the just completed second-quarter, the latest consensus estimate for the S&P 500’s year-over-year earnings growth rate is 20%.

But much of this earnings growth is fueled by government stimulus, a “sugar high” if you will. The $1.5 trillion tax cut is a windfall for corporations, but the boost will eventually wear off.

Investors seem attuned to these risks. Since peaking in late January, global caps have lost about $10 trillion.

As the second half of the year gets underway, small-cap stocks are getting more attention, in large part because they’re better insulated against a trade war.

Smaller companies also are more resilient in the face of Federal Reserve tightening because their collective fate isn’t tied to interest rates, whereas large-cap growth stocks tend to lag as rates rise.

Indeed, small caps have been outperforming large caps since the bull market began in 2009 (see chart, compiled with Bloomberg data):

In the holiday-shortened week ahead, additional data will help us determine how much steam the economy has left:

Tuesday: motor vehicle sales, factory orders.

Thursday: ADP employment, weekly jobless claims, ISM non-manufacturing index.

Friday: non-farm payrolls, unemployment rate, average hourly earnings.

Today’s takeaway: Ease back on stocks with exuberant earnings expectations; focus on value. Rotate away from large-caps and toward the “small fry,” which are poised to continue their outperformance.

The yield curve is a leading indicator, so it will take a while for the adverse consequences I’ve described to show up. But when the day comes, you don’t want your portfolio exposed.

Monday Market Wrap

• DJIA: +0.15% or +35.77 points to close at 24,307.18
  
• S&P 500: +0.31% or +8.34 points to close at 2,726.71
  
• Nasdaq: +0.76% or +57.38 to close at 7,567.69
  

Monday’s Big Gainers

• Roadrunner Transportation Systems (NYSE: RRTS) +36.60%

Logistics firm posts strong earnings.

• VMware (NYSE: VMW) +10.19%

Cloud software developer announces special dividend.

• Dell Technologies (NYSE: DVMT) +8.93%

IT solutions provider near deal to acquire VMware tracking stock.

Monday’s Big Decliners

• Gemphire Therapeutics (NSDQ: GEMP) -17.96%

Biotech battered by departure of CEO.

• Nuvectra (NSDQ: NVTR) -15.34%

FDA skeptical about biotech’s neurostimulation product.

• Stein Mart (NSDQ: SMRT) -14.69%

Analysts turn bearish on fashion retailer.

Letters to the Editor

“How pronounced is volatility this year?” — James F.

The first half of 2018 witnessed a huge spike in volatility, with 29% of trading sessions posting moves greater than 1% in either direction, compared with only 3.2% of trading days in all of 2017. Trading was choppy today as well.

Questions about market volatility? Give me a shout: mailbag@investingdaily.com

John Persinos is managing editor at Investing Daily.