It is often said that equity markets fall like an elevator and rise like an escalator. We have seen that description hold true these last two weeks. The elevator rode down last Monday August 5th after the US tariff increase on China and the yuan devaluation only to slowly climb its way back up. It took another elevator down on this week on Wednesday August 14th as the US Treasury 10-year yield dipped below the 2-year causing recession alarms to ring.
With all of the media angst in the past ten trading days, it is important to take a step back for perspective. Adding up the back and forth, the S&P 500 is only down about 1.5% quarter-to-date, bringing year-to-date returns to a little over 16%. When the equity market falls 3% in a single day, it can cause a lot of heartburn and headlines. Traders can be forgiven for being a little emotional with uncertainty on trade, Brexit, monetary policy, HK protests, and forth. We also wonder with all of the algorithmic trading volume, how much price action in big-move days is driven by computers when there is a “signal” in the market.
Reality is that the issues of uncertainty did not pop up overnight. We have long discussed that the “trade” issue between the US and China is a broader power struggle and it should be no surprise as both countries pull out non-trade related tools to fight it. It is also our view that neither side seeks an acute confrontation despite brinksmanship. The desire for judicial independence and social justice in Hong Kong is long-standing; protestors are leveraging general economic weakness by adding disruption to make their case. Brexit has been on the docket for the last three years. And, finally, whether the Fed wanted to rein in market expectations for further easings, they are back on the hook for several more cuts throughout the year.
We take the yield curve’s inversion seriously, starting back when the 3-month and 10-year crossed paths last year. The inversion of the 2-year and 10-year is not a surprise at this point given conditions. Expectations of growth, inflation, and short-term interest rates have fluctuated wildly in the three weeks since the July Fed meeting. Bond markets are telling the Fed they are too tight, but unless the Fed acts between meetings (unlikely, though possible) they have to wait until September to see whether they listen. With the short-end of the curve tethered to the policy rate and the long-end driven by expectations, it is no wonder the curve is flat.
Saying a recession is coming is like saying there will be nightfall. Everyone knows it is going to happen eventually.
Unfortunately, the economic cycle is not as predictable as the solar cycle. More often than not, the economic cycle is triggered by a policy mistake (monetary and/or fiscal) or an exogenous shock rather than the ticks of a clock. It is certainly possible for the Fed to ignore the bond market’s message (which would be a mistake) but it is not our base case. Just like the solar cycle though, the sun will rise again. As long-term investors, knowing that we will be investing through the ups and downs of many days will help your emotions from being taken on a ride.
Will Skeean, CFA
Partner – Investment Management Team Chair