A Sharp Reversal of Fears
We titled our Q4 2018 commentary, “The Year When Nothing Worked,” because virtually every index finished in the red after a large drawdown in December. At the time, we felt the sell-off was overdone and believed the market would be poised for a recovery. And, as our analysis suggested, Q1 2019 proved to be the exact opposite of Q4 2018; it was the quarter where nearly everything worked. Virtually all asset classes produced positive returns, from U.S. and International equities of all sizes and sectors, to higher quality bonds and junk bonds, and, yes, even commodities floated with the rising tide.
We believe the primary reason for the rally was a swift reversal of two fears that drove the fourth-quarter sell-off: the Federal Reserve’s (miss)communication and trade concerns. Trade concerns still exist but they are ebbing, and the Federal Reserve not only clarified its communication but left little doubt about its plans to remain extremely dovish moving forward. Jerome Powell enlisted the past two Fed chairs, Janet Yellen and Benjamin Bernanke, to drive home this less aggressive positioning during the annual American Economic Association meeting in January. Powell struck all the right tones with investors in his opening comments, which stressed patience and listening to markets. Yellen further soothed concerns by reminding those in attendance that economic expansions don’t die simply because they are long in the tooth – a growing fear given the current cycle could soon become the longest continuous expansion in U.S. economic history. Rather, she said, economic cycles die because the Fed decides to kill them. Financial instability, typically in the form of inflation, is what causes central banks to pull the trigger, but there are few signs of instability, Yellen said. Bernanke added that investors were reading the current Fed’s intentions wrong; no one at the Fed is lurking behind the curtain ready to stick a knife in this expansion. Given the strong 2019 rally, it appears the trio of Fed chairs successfully calmed investor jitters.
U.S. Economic Stability vs. International Wobbling
While parts of the U.S. economy downshifted from the strong pace set in mid-2018, a preponderance of data still shows an overall economy that’s pushing ahead at a steady clip. We remind that beyond lumpy month-to-month gyrations in the numbers, the underlying fundamentals of the U.S. economy still appear to be firm. Most importantly, consumer balance sheets remain healthy and workers are now getting real wage increases. Paychecks grew at a year-over-year pace of 3.4 percent, all against a backdrop of contained inflation. Companies continue to hire and are investing in their businesses, which has boosted worker productivity. Lastly, though credit conditions have tightened, lending remains accommodative.
While market returns were positive outside of the U.S., a cloud of uncertainty and a steady stream of underwhelming economic data left little to be inspired about from the Eurozone and Chinese economies. Indeed, weak Eurozone manufacturing data in March sent government bonds around the globe rallying. The German 10-year Bund fell into negative yield territory for the first time since 2016. The search for positive yields led investors to U.S. shores, driving yields on U.S. 10-year Treasury notes from 2.75 percent at the beginning of March to 2.36 percent by month’s end. Because the yield on a 3-month Treasury bill remained anchored near 2.4 percent, the 3-month/10-year Treasury yield curve inverted, leading to chatter that an economic recession lies on the horizon.
Does the Yield Curve Inversion Signal Impending Doom?
The Treasury yield curve has rightfully earned its forecasting credibility, as it has inverted before each of the past recessions. However, that doesn’t mean a recession follows every time the yield curve inverts – there have been false-positives. Allow us to point out some important details we believe indicate it may not yet be the recessionary and market menace that many are predicting.
First, we should point out that the recent 10-year/3-month Treasury bill inversion was short-lived, and as of this writing it has moved back to positive. We also note that while various parts of the yield curve have inverted, other important curves have not. The 10-year/2-year Treasury curve, for example, still has a positive slope of 0.18 percent. While it is only slightly to the positive, it is still positive.
Secondly, as stated above, yield curve inversions lack a perfect forecasting record. The Treasury yield curve has predicted nine of the past seven recessions, which means there were two false signals in that time. The first was in the fall of 1966, a period we have written about extensively because we believe today’s economic conditions and Fed actions mirror that time in history. Back then, just like today, the Fed was determined to not kill the economic cycle and opted to let the economy “run hot” because inflation had been so weak. The other false-positive occurred during the summer/fall of 1998 when international economic weakness (the Asian Currency Crisis) threatened to storm U.S. shores. We believe this also rhymes with current worries about contagion from sluggish international economies. In 1966 and 1998, the yield curve re-steepened (to a positive slope) until it once again inverted before the next recessions occurred. This is key: The recessions that followed didn’t occur until December of 1969 and March of 2001; approximately 3.3 and 2.5 years later, respectively.
Thirdly, while much has been written that the market continues to rise following an inversion only to reach new lows during the ensuing recession, we note that in at least one instance an inversion missed the mark altogether as a market-timing indicator. On Dec. 12, 1988 the 10-year/2-year Treasury curve inverted and was joined by the 10-year/3-month curve on March 28, 1989. The S&P 500 Index resided at 275 and 291 when each of those inversions began. A recession did follow, but it didn’t begin until July 1990 when the S&P had risen to 359. Those who sold their stocks on Dec. 12, 1988 to preempt the recession would’ve missed a gain of over 37 percent when adding in dividends, and over 28 percent if they bailed on March 28, 1989. Most importantly, during the recession, which lasted until March 1991, the S&P only fell to a low of 295. In other words, the market didn’t go below levels you would’ve sold out on to “prepare for the recession” on either of the inversion dates. An investor who sold in December of 1988 would’ve missed out on 7.5 percent annualized gains, and those who sold in March of 1989 would’ve forgone 4.4 percent annualized gains. While it’s always dangerous to say this time is different, we believe it is very reasonable to draw analogies between the prior non-recessionary inversions and this most recent inversion. And while a yield curve inversion certainly points to an aging economic cycle, we once again point to the Fed’s desire to keep the expansion going.
A Helping Hand from Fiscal Friends
Believe it or not, the Presidential election season is already upon us. While we will likely spill more ink on this topic in the future, we thought it would be useful to introduce an election season topic that promises to be at the forefront: Should the government continually spend more in an attempt to improve economic outcomes?
It’s a conversation that ballooned earlier this year after the economic advisor to Democratic candidate Bernie Sanders pushed the concept of Modern Monetary Theory (MMT) in various interviews with the press. Without swimming too deep into the various tributaries of this theory, the basic idea is that deficits don’t matter to countries like the U.S. that print their own currency and, therefore, “can’t” default. Because of this, the theory goes, the U.S. should never be afraid to deficit spend to keep its economy pumped full of fiscal stimulus, especially when inflation is not high. Fiscal stimulus should only be throttled when inflation reaches some magic number – it’s not clear what that number is. If William Prescott, an officer during the Revolutionary War, was an MMT economist, he’d probably say, “Borrow and spend until you see the whites of inflation’s eyes.”
While contenders for the Democratic nomination will likely debate MMT, we also point out that President Donald Trump, assuming he runs and wins the Republican nomination, isn’t necessarily a deficit hawk. Case in point: The recently submitted budget from the White House doesn’t balance for 15 more years.
The Bottom Line
While economic storm clouds appear to be gathering on the horizon, we believe there is still time left in this economic cycle. We continue to believe the underlying “do more monetarily and now fiscally environment” points to this cycle ending only after a brush with inflationary pressures. And it’s not just in the U.S. but across the globe that policy has tilted back to dovish, especially in China. Given this, we believe the next leg higher in markets will occur when investors realize international growth didn’t fall into the abyss as feared. We remind that last year the Chinese government was attempting to slow its economy and got caught flat-footed by unexpected tariffs. Contrast that to today where China is now attempting to stimulate the country’s economy while tariff threats ebb. We note that recent economic data out of China has improved in turn.
Even with this moderately positive outlook, let us close with a crucial point for all investors. For those reading this who were panicked during the fourth quarter when “nothing worked,” please take a moment now during these good times to ask yourself if you will be able to stay the course during the next market sell-off. Now is the time to reflect and make necessary adjustments, not in the teeth of a sell-off when the urge to push that sell button grows all too tempting. Market corrections are inevitable, and one will occur again in the coming years. Regardless, the recipe for long-term portfolio success remains the same: maintain a steady hand during tough times. Review your plan and make sure that each asset in your portfolio helps you fulfill your financial goals, and make sure that your portfolio’s exposure to risk matches your ability to tolerate it.
Commentary is written to give you an overview of recent market and economic conditions, but it is only our opinion at a point in time and shouldn’t be used as a source to make investment decisions or to try to predict future market performance.
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