Last Monday, equities rallied on initial optimism about U.S. and China trade progress at the G20 meeting, only to see the major U.S. indexes sell off sharply in subsequent sessions and lead the rest of the world lower as fears about the U.S.-China relationship came back to the fore.

 

While there have been a number of issues fueling the correction since early October, concerns about U.S.-China tensions have been toward the top of the list lately. Equity markets, especially in the U.S., have also been preoccupied with the further flattening (and partial inversion) of the Treasury yield curve. Ongoing Brexit uncertainties have also been a factor.

 

While our key forward-looking indicators continue to flash green, these risks do warrant investors’ attention.

 

This trade war is about more than trade

Headlines about the U.S.-China trade discussions shifted from positive, to conflicting, to negative, and then back to positive, and then once again back to negative—all in less than a week. From our perspective, the official government statements and press reports should be taken with a grain of salt. The U.S. and China may very well cobble together a trade pact within the 90-day window, but other issues could complicate the relationship over the mid- and longer term.

 

Underscoring this point are multiple press reports of the arrest and request for extradition of a senior executive of China-based Huawei, the world’s largest telecommunications equipment firm, for allegedly violating U.S. sanctions against Iran. The U.S. is confronting China on a number of levels, and that is unlikely to end in 90 days.

 

The yield sign

When the Treasury yield curve inverts (when short-term yields are higher than long-term yields) we have two rules of thumb.

 

First, don’t react too quickly. Inversions typically occur quite far in advance of a forthcoming recession rather than striking right before an economic contraction occurs. Since the 1950s, it took 14 months after inversion, on average, for a U.S. recession to begin. The S&P 500 peaked almost six months after inversion, on average, although there was a lot of variability around the mean.

 

Our second rule of thumb is, once the 10-year to 12-month yield curve does invert (it inevitably will), don’t try to rationalize it away by saying “this time it’s different.” While there are usually a number of reasons for the situation to be “different” in each business cycle, in the end recessions normally follow yield curve inversions. In our view, it’s prudent to take the yield curve’s track record seriously.

 

Backing off the Brexit cliff edge?

Two Brexit risks could have a substantial negative impact on financial assets: a no-deal, cliff-edge Brexit and a far-left Labour government. Two recent political developments suggest that the probability of the former has receded somewhat.

 

First, Parliament reasserted itself by voting in favor of an amendment that would give it more say on the plan of action if Prime Minister Theresa May’s Withdrawal Bill, due to be voted on in the House of Commons on December 11th, were to fail to pass. Rejection of the bill is widely expected, given the widespread opposition to it in Parliament.

 

The second event is an opinion from an Advocate General of the European Court of Justice (ECJ) that the U.K. Parliament could unilaterally revoke Article 50, the two-year process of leaving the EU.

 

We stress that both events are non-legally binding. Yet, combined, they could enable the largely pro-EU Parliament to revoke Article 50 if the U.K. was seen as heading toward a no-deal Brexit, if the opinion of the Advocate General were to be confirmed by the ruling of the ECJ. Precedents suggest this is likely to be the case.

 

Our base case remains that the Withdrawal Agreement will eventually be approved, and that the U.K. will exit the EU, but the uncertainty could drag on.

 

Balancing act

The risks related to U.S.-China relations, the Treasury yield curve, and Brexit will likely remain on equity markets’ radar screen over the near term, and other uncertainties could also resurface as markets work through this correction period. These risks should be balanced against reliable leading economic indicators, in our view.

 

Thus far, our indicators are not signaling an elevated threat of recession, and therefore we maintain a Market Weight recommendation on overall, global equity exposure in portfolios, and for U.S. exposure as well.

 

We are closely monitoring leading indicators and other data because when they ultimately shift, it will be time to position equity portfolios more cautiously and defensively. At this stage, dramatic portfolio changes are not yet called for.

 

Tim