Always Be Prepared

Key Points
  • Recent stock market action reminds us how quickly things can change. It’s also a reminder that seemingly-subtle shifts in the direction of fundamental data can lead to significant moves in the markets.

  • Heading into this month, markets were breathing easier over the apparent trade agreement among the United States, Mexico and Canada; however, the potential higher stakes battle continues to escalate with China, which has been one of the market risks we’ve been citing all year. Add to mix the ongoing tight labor market, and a seemingly more hawkish Federal Reserve and you had the recipe for a major pullback.

  • The correlation between bond yields and stocks has shifted to an inverse relationship; both here and globally, which could be sounding a further warning sign for investors.

“It wasn’t raining when Noah built the ark.”
- Howard Ruft

Storm clouds building?

As anyone who has had the misfortune of riding out a severe storm knows, the time to prepare is before the event, not during. Likewise, preparation for inevitable market corrections should be looked at while the skies are clear, because storms can come up quickly. There were several contributors to this past week’s rout; not least being U.S. Treasury yields breaking out to multi-year highs, causing consternation among equity investors and contributing to the sharpest two-day pullback in equities that we’ve seen in months.

Yields breaking out to new highs…

10-year Treasury yield

…pressuring U.S. equities

S&P 500 Composite Index

Our fixed income team doesn’t believe yields will move significantly higher from here, but investors should be prepared in the event they do (more on that below). We do believe we have passed a threshold of sorts with regard to the relationship between bond yields and stock prices. During deflationary/disinflationary periods—like the one we’ve been in since the financial crisis—bond yields and stock prices tend to be positively correlated. But once disinflation gives way to higher current and expected inflation, the correlation between bond yields and stock prices tends to move from inverse to positive. This is what we are recently seeing. We do not think this warrants that investors flee for the equity exits, but our more cautious stance over the past year keeps us in the camp of recommending that investors have no more than their normal long-term allocation to equities (hence our “neutral” rating on stocks). At a more tactical level, we recently moved to a more defensive stance from a sector perspective, and believe health care may be a good place to look for potential opportunities in the current environment, read more at Health Care: The Right Prescription?