“The conventional view serves to protect us from the painful job of thinking”
John Kenneth Galbraith, Renowned Canadian Economist
Late last year, the stock market threw a hissy fit when the Federal Reserve stuck by its plans to raise interest rates. The central bank was planning to raise rates three times in 2019. Traders didn’t like that at all. Between September and December, the stock market tanked. The Fed eventually got the message and backed off. The stock market snapped back quickly. It rallied much faster than I had expected. Now we’re in the spring, and the stock market is unhappy again. The major indexes took a bath during May. The selling really got going after a pair of tweets from President Trump escalated the Trade War with China.
Will the Fed come to the rescue again? That’s what the bond market thinks. In anticipation of rate hikes, the yield on the two-year Treasury has fallen off a cliff. The two-year is often a decent proxy for Fed policy. It fell from 2.26% on March 21st to 1.82% this past Monday. That’s a big move for such a short amount of time. The futures market agrees. The Fed funds futures now thinks the Fed will cut rates at its July meeting, and again at its September meeting. This is a huge about-face from a few months ago. In fact, the futures are split on the odds of a third rate cut in December. This has led to the yield curve becoming partially inverted. Of course, with rates already so low, the Fed doesn’t have much room to cut rates.
After ten years, the yield curve has finally gone flat. Ironically, this was caused by decent economic news. A flat curve is usually a natural response to a growing economy, but a flat yield curve also has some important implications for the economy, the stock market and of course, investment portfolios.
Wall Street has been in a mood over the yield curve. As we all know the “street” loves to stress about something all the time. The “street’s” favourite mode is being “concerned” and every now and then that gets upgraded to ”distressed”. In my experience, most of the time the “concern of the year” is usually over-rated.
Yes, an inverted yield curve can be a big deal. A normal yield curve is upward sloping, an inverted one comes into play when short term interest rates are higher than long term interest rates, thus creating an “inversion”.
The thing is, an inverted yield curve has been one of the few good predictors of a bad economy. The spread between 2 and 10-year rates has been an omen of bad times consistently for the last 35 years.
That’s a better track record than most economists.
To give you an idea how much things have changed, in 2011 the 2/10 US Treasury spread peaked at 291 basis points. Today it’s about 16. The spread between the 3-month and 10-year is currently negative by about five basis points.
While the yield curve is important, it’s not a lay-up. The 2/10 spread inverted in May 1998, went back, and inverted again in 2000… but the recession didn’t officially begin until 2001. Even the last cycle, the yield curve in late 2005, but the recession kicked in over two years later in 2007.
In March’s policy statement, the US Federal Reserve finally came out and agreed with that markets were saying when it announced it would not raise rates in the near future. The language also mentioned it “will be patient” in regards to further rate hikes.
The Fed also lowered their growth expectation for the US economy in 2019 to 2.1%. That’s down from 2.3% in December. As for 2020, the Fed sees the need for just one rate hike, and none for 2021. But we all know that can change with the latest economic data point.
Markets wise, a 14% decline in Q4 2018 on the S&P 500 was followed by a 14% gain in Q1 2019, once again reinforcing that sometimes the best action for an investor is to do absolutely nothing.
S&P 500 Large Cap Index INDX (Source: StockCharts.com):
Stocks had a V-shaped recovery and while one quarter doesn’t make a year, it’s a pretty good start. As investors, we have to make assumptions as to where we are in the business cycle. I’d say the bulk of what I read consistently refers to “late cycle”, but if that is consensus, consensus can often be very wrong.
From what I have read and hear in conversations, I can’t see a US recession kicking in 2019, maybe in early 2020, but it is rare we see the US economy tanking going into a presidential election. They are usually doing their best to juice things up, so that takes us past the US election into early 2021.
Other indicators that usually convey a cycle peak give me confidence as well:
- Sentiment – Despite a bull market run over 10 years old, I would say investors remain a nervous and cautious bunch overall. In 2019 investors sold a staggering $147 billion of equity funds and ETF’s. Those are not numbers we see at tops. (Source Fidelity Investments – Insights May 2019)
- Liquidity – The Fed seems done raising rates after nine hikes totalling225 basis points, on top of about $800 billion in balance sheet reductions.
- Earnings & Valuations – The S&P 500 price-earnings (P/E) ratio sit at about 16.7x expected earnings. Not cheap, but nowhere near expensive.
This continues to be an interesting time in the markets. Despite what seems to be an onslaught of negative news, including a tariff laden trade war between the two largest economies on the planet, we are but 4-5% off all-time highs on US markets. If the Fed continues its dovish path and earnings stabilize in the back half of 2019, the new highs for the major averages might not be far behind.
Add on that any good news on the trade front and we can get serious “lift off”.
Stay Tuned,
Vito Finucci, B.COMM, CIM, FCSI
Vice President and Director, Portfolio Manager
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