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Special Market Note: August 2019

August 20, 2019 | Weekly Commentary

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After both equities and bonds managed a strong rally to begin the year, a variety of factors have combined to affect markets over the past few weeks. A sudden re-escalation (and then de-escalation) in the U.S.-China trade war, large swings in global currency valuations, speculation surrounding Federal Reserve policy, and an inversion of the 10-year and 2-year treasury rates have all added to uncertainty and created a bumpy ride for investors. Below, we offer our perspective on recent events and provide some context that we believe can help investors stay grounded and disciplined amid all of the uncertainty.

An Update on China and Trade
On July 31, the Federal Reserve opted to reduce its target interest rate by 0.25% for the first time since 2008, and the very next day, in what was likely a calculated decision, Donald Trump announced that the United States would be imposing a third round of tariffs on previously untaxed Chinese exports. The announcement led to a relatively meaningful decline in the value of the Chinese currency (the renminbi), which likely reflected the market’s belief that the tariffs would materially weaken the Chinese economy. However, the Trump administration was quick to accuse the Chinese of taking active measures to manipulate the value of the renminbi in order to offset some of the effects of the tariffs (a weaker renminbi makes Chinese goods more affordable for foreign buyers, and can counter the decline in demand created by U.S. tariffs). 

The rising (and very public) tension between the two countries has been a source of anxiety for investors and business leaders around the globe. Global manufacturing activity has declined precipitously as the uncertainty surrounding global trade patterns has mounted, and while we continue to believe that a deal between the U.S. and China will eventually be reached, the complexity of the negotiations is likely to contribute to volatility in the interim. However, experts on economic policy seem to unanimously agree that free trade is beneficial for all parties involved, and it is this fact that is likely to win out in the end.

Don’t Overreact to a Yield Curve Inversion
During early trading on August 14, the 10-Year U.S. Treasury rate dropped below that of the 2-year rate, and the “inversion” of these two critical interest rates prompted a slew of risk-off trading. Equity markets sold off as investors pondered the significance of what is widely considered to be a key portent of recession. At this point in time, we caution against overreacting to movements in the yield curve for two primary reasons:

1. History Suggests There’s Likely Still Meat on the Bone
While yield curve inversions have been relatively reliable in predicting recession, the lead time has varied considerably.  In fact, according to data gathered by Credit Suisse, the last five times that the 10-Year and 2-Year yields inverted, there has been an average of 22 months until recession occurred. Furthermore, the S&P 500 has moved an average of 12% higher over the 12-month period following the inversion.

2. There Are Reasons to Question the Predictive Power of the Inversion Historically, yield curve inversions have taken place because the market expects economic growth and inflation to be lower in the future than they are now. This leads bond investors to demand a lower yield from their investments and thus the inversion takes place solely as a result of market forces. However, there is some reason to believe that in the current environment, there are additional external pressures on the bond market that may be influencing the shape of the curve; possibly reducing its predictive value. 

First, the active role that the Federal Reserve has taken in managing the current economic cycle has been much more significant than in the past. Despite the recent rate cut, the Federal Reserve has increased its target interest rate by 2% over the past four years, pushing near-term interest rates higher in the process and contributing to a significant flattening of the curve. Secondly, economic weakness in other parts of the world has led to aggressive measures being taken by many central banks outside of the U.S. At present, a staggering $15 trillion worth of bonds in 19 different countries now carry negative interest rates; a phenomenon never before seen in economic history. This has put immense downward pressure on U.S. yields as foreign investors have moved money to the United States in an attempt to capture positive income. It is almost impossible to quantify the exact degree to which this has impacted U.S. interest rates, but it has unquestionably contributed to the major decline in longer term U.S. bond yields over the past several months and years. When we combine these two forces (upward pressure on short-term rates coming from Fed policy, and downward pressure on long-term rates coming from foreign demand), it makes sense that the yield curve has continued to flatten so significantly. And if the curve has been pushed into inversion territory by outside pressure rather than pure market forces, it begs the question as to whether the “signal” is as strong as it might have been historically.  In any case, we believe that the yield curve inversion should be interpreted as a component of a global mosaic, rather than a surefire predictor of impending economic turmoil, and that it should never be used as a market timing mechanism.

We continue to remind clients that volatility is a normal part of investing. In fact, the very existence of volatility and risk is why markets have generated positive returns throughout history. It is also why planning is such an important aspect of the investing process. If we do our homework up front and build the right portfolio to meet our goals, it takes a lot of the worry out of investing during difficult times. 

As always, we are here to answer any questions you may have, and to help you assess whether you are on track to achieve your financial goals. If you would like to discuss any of the above in more detail, please do not hesitate to contact us.