Large market swings tend to bring feelings of angst and uncertainty. In such moments, we feel it is important to keep our clients up to date with our thinking. Although there is not a direct link between any one issue and the recent market pullback, it is natural to want to draw conclusions based on recent headlines. Our view is that the U.S. economy — currently strong — will likely decelerate somewhat in the coming quarters. We will seek to define and describe some of what is driving the markets but feel it is important to state that at this time we do not believe the U.S. will enter a recession in 2019.
Not One, But Many Factors
There are multiple issues weighing on the markets: weaker global economic data, potential Fed hikes, an inverted yield curve, trade uncertainty, political uncertainty, and now Brexit. There is a capital reallocation occurring in favor of safe assets (generally bonds and gold). Additionally, the news this week that Canadian officials arrested the CFO of Huawei (the iconic Chinese equivalent of Apple) exacerbated the tone as the global markets continued to trade lower.
That said, even with these issues, the U.S. economy remains on strong footing. While the above factors are concerning, they should not be enough to derail an otherwise healthy economy. As their outcomes are uncertain, they do contribute to the fear and malaise currently being expressed in the markets.
We monitor several U.S. economic indicators that we believe are reliable predictors of recession. Some of the more important ones include:
- S&P earnings
- Corporate profits
- Housing market
- Banks’ willingness to lend
- Yield curve inversion/Federal Reserve moves
- High yield spreads
- Employment levels
At this time, none of these indicators has rolled over. As we look to 2019 guidance by company management teams and study economic data, we will continue to look for data that changes our underlying view. Of course, future cycles can be different from past cycles, but we will be watching these indicators closely.
Capital Reallocation and the Yield Curve
The recent volatility in the stock market — regardless of cause — has unnerved investors as the future strength of the economy comes under increasing scrutiny. As a result, many investors have sought the safety of the bond market. This reallocation of capital has caused the slope of the yield curve to flatten and, in shorter maturities, invert.
An Inverted Curve
The “normal” shape of the yield curve is generally upward sloping, with yields increasing as maturities extend. Conversely, a negatively sloped, or “inverted” yield curve, occurs when long-term yields fall below short-term yields. This inversion typically reflects expectations of a weakening economy.
On Monday, the yield on five-year Treasurys fell below that of two-year Treasurys for the first time since 2007. That news unquestionably contributed to the fall in stock prices on Tuesday and again yesterday.
Inverted Yield Curves Do Not Cause Recessions
To date, the more commonly followed spread (between the two-year Treasury and the ten-year Treasury), though close, has not inverted. Inverted yield curves do not cause recessions; they reflect a market assumption that growth will slow, based on market perception and data that is available.
Lastly, it is important to note that an inversion of the yield curve does not typically mark the high point for equity markets. Since 1978, there have been five examples of a yield curve inversion, and in every instance, the S&P 500 continued to climb even after the onset of the inversion. We feel this cycle should be no different and expect the markets (however volatile) to continue higher once some of the issues mentioned above are resolved.
We want to reiterate that for now, we are not making any changes to our recommended asset allocations. There are several reasons to be optimistic that this current market volatility — unnerving as it may be — is a normal correction and not the start of something bigger. Those reasons include:
- Equities can be viewed as fairly valued at 15.5x forward earnings compared to the five-year average of 16.4x — although still above the ten-year average of 14.6x.
- Earnings growth expectations for the S&P 500 next year are still positive at 8.6% with revenue growth of 5.6%.
- The U.S. consumer is doing well, and the recent drop in oil prices is likely to boost household purchasing power. The U.S. employment reports show firms continue to hire workers.
We encourage you to contact your portfolio manager to discuss any concerns that you may have regarding your investments.
Jon is Senior Vice President, Director of Fixed Income and Investment Strategy at Pennsylvania Trust.
Disclosure: This Commentary represents a review of topics of possible interest to Pennsylvania Trust’s clients and is not personalized investment advice. It contains Pennsylvania Trust’s opinions, which may change following the date of publication. Information obtained from third-party sources is assumed to be reliable but is not guaranteed. No outcome – including performance – is guaranteed, due to various uncertainties and risks. This document is not a recommendation of any particular investment. Investment decisions for clients are made on an individualized basis and may be different from what is expressed here. Past performance is no guarantee of future results.