To my clients:
First, an announcement: I will be away from the office next week for the second week of Spring Break. As clients will note as they read today’s update, there was a significant development in markets this week and, as a result, I will be considerably more engaged while away than might normally be the case. At this juncture, I don’t intend to write an update next Friday, although this may change as circumstances play out.
It was a down week for North American stock markets with the Canadian TSX falling 0.3%; the U.S. Dow Jones Index falling 1.3%; and the U.S. S&P 500 falling 0.8%.
There were some important developments this week, as well as activity in discretionary client portfolios.
The developments first:
- The U.S. Federal Reserve’s policy announcement on Wednesday of this week unsurprisingly left the overnight rate unchanged. However, there was a material change in future rate expectations insofar as the Fed removed guidance for any more rate hikes in 2019 (previously there were two more hikes forecast). Beyond that, the Fed now only anticipates one more hike in future forecast years (previously there were three). Further, in September, the Fed will stop the unwind of the bond portfolio it acquired as part of the various iterations of the Quantitative Easing Program it implemented for several year coming out of the 2008 recession (i.e. it will stop the so-called quantitative tightening program). In conjunction, these two moves were more extreme than the market had anticipated and, while the economy and markets usually prefer lower rates to higher rates, in this case the market is becoming concerned that the Fed is, perhaps, seeing a more extreme economic slowdown on the horizon. That said, Powell’s specific quote on the matter was “the reason we’re on hold is that we think our policy rate is in a good place, and we think the economy is in a good place (emphasis Nick’s)”.
- German manufacturing data was released this morning and it moved deeper into contractionary territory. Germany is Europe’s largest economy, and this is certainly a concerning development. As a result, the 10-year German bond yield fell back into negative territory and now sits at its lowest rate in 2 ½ years.
- The combination of the U.S. Federal Reserve policy announcement, combined with today’s contractionary German manufacturing data, finally triggered a negative U.S. yield curve. Recall that an inverted yield curve means that short-term rates are now higher than long-term rates. Recall also that an inverted yield curve is one of the most reliable indicators of future recession, although it must be emphasized that the lead time can be anywhere between 9 months and 3 years. Further, it has historically been the case that stock markets often continue to rise after a yield curve inversion (at least until recession hits). To wit, within the past 24 hours, RBC’s U.S. Equity Strategy team actually raised its target for U.S. equities for the remainder of 2019.
And now for the portfolio activity:
- Earlier this week, I rebalanced many client portfolios back to their targeted model weights (not all portfolios were rebalanced, as there remain a handful for which I am still attempting to replenish positions sold as a result of tax loss harvesting executed late in 2018). Rebalancing is a fairly common practice that I intend to do about once per year and resulted in some positions being reduced, while others were increased.
- However, with today’s yield curve inversion, I strategically reduced equity exposure by about 5% for most clients (with some exceptions involving those client accounts where cash from tax loss selling remains uninvested). The ebb and flow of the rebalancing buys and sells earlier this week, combined with today’s outright sales may be confusing, but the bottom line message is that equity weightings for clients are now about 10% less than they were at this time last year (5% reduction in October, and another 5% today).
- I may reduce equity weighting further as economic developments play out, especially if a) other economic indicators RBC tracks confirm the yield curve move (as of now, none do: all 5 of the other main indicators we track continue to flash a solid green light); or b) the yield curve moves more substantially into inversion (today’s inversion saw short-term 3 months yield move just 0.01% above 10-year rates). Interestingly though, despite the unblemished track record (since World War II) of yield curve inversion preceding recession, in discussion with managers of PIMCO (the world’s largest bond fund managers) earlier this week (i.e. before today’s inversion), I was told that their belief is that the U.S. Fed may have engineered the “unicorn” of economics… the so-called economic “soft landing”. A soft landing is where an economy begins to slow and the central bank modulates the “gas pedal” (the “gas pedal” being interest rates) just enough so as to prevent the onset of recession. I’ve referred to this outcome as a “unicorn” because many economists believe, just like a unicorn, it has never been seen before. But if PIMCO is right, it just might be the case that an unprecedented soft landing also breaks the inverted yield curve’s unblemished post World War II track record.
- Regardless, I’ve long vowed not to ignore the implications of yield curve inversion, and today I did not. I will continue to vigilantly monitor.
That’s it for this week. Next scheduled update on Friday, April 5th (although there may well be an unscheduled update next Friday depending upon developments). All the best,
Nick Scholte, CIM, FCSI
Vice-President & Portfolio Manager
RBC Dominion Securities Inc. │ Tel: 604.257.7569 │ Fax: 604.235.9950
3200-1055 West Georgia │ Vancouver, BC │ V6E 3P3
Toll Free: 1.844.665.9900 │ email@example.com
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