Broader market indices drifted lower last week. Though it could have been worse. Following the previous Thursday’s move higher, the market plummeted four percent. Falling Friday through Wednesday. Only to claw back two percent of those loses last Thursday and Friday.
Why the quantum leap in volatility?
The dreaded yield-curve inversion broke the water’s surface. Leaping and twisting like a crazed, sun-drenched marlin that can’t take enough line. And when the lethargic anglers on the boat’s stern caught sight of such an oft-discussed yet rarely seen apparition, their collective yawl was enough to alert those half a sea away.
After years of inversion-related banter, yields on the 10-year Treasury fell below two-year yields for the first time since 2007. The yield curve typically inverts because investors feel better about long-term economic prospects than those in the immediate future. Rendering them willing to accept a lower rate of interest to park capital well into the future, or further out on the yield curve.
The bad news? The two- and ten-year inversion has preceded the last seven recessions. Yet, that does not mean a recession is imminent. Only Tuesday, the Trump administration had delayed plans for new tariffs on Chinese goods. Sending equities markets skyward and investors spooning up risk like it was grandma’s tomato bisque. Only to see such optimism upended by news that yields on 10-year notes has drifted beneath those of the two year.
Of course, recession is not only likely in the future, but absolutely certain. The business cycle begins and ends as such. In the teeth of despair at the depths of a downturn. And eventually rising on the wings of hope and optimism. As economic growth becomes a rising tide that lifts all boats.
The two- and ten-year yield curve inversion represents one of five indicators our team uses to determine how far out an economic downturn might reside. Currently, this week’s inversion stands as the only one indicator of the five flashing red. And even that has reversed course, with the ten year now sitting above the two year.
Traditionally, markets tend to keep moving higher immediately following a yield-curve inversion. Since 1978, the S&P 500 has risen 13 percent on average from the first time the spread inverts to the beginning of a recession.
This inversion, however, will be particularly disconcerting to some investors given its arrival on the heels of the Fed’s recent rate cut. Likely leaving many market watchers to expect and desire additional Fed intervention so that we might extend the economic expansion.
In fact, expectations for further rate cuts jumped Wednesday. With Fed-funds futures showing a 20-percent market-implied probability that the Fed cuts rates by 50 basis points in September. Up from four percent odds only the day before.
Should this indicator prove prescient at some future date, there’s still no telling when that may occur. Nor the severity of the forecast recession. While the yield-curve inversion ranks as one of our top-five recession/bear market indicators, it represents only one tea leaf. Comes with no guarantees. And zero prescriptions for what may (or may not) lay ahead.
It will, however, bring us to don our most highly acute headphones and inch closer to the radar screens before us. Listening exhaustively for other telltale pings that may confirm the idea that, yes, danger lurks in the murky depths through which we’re navigating.
As we learn more, we’ll report our findings. For now, the S&P 500 remains 15.23 percent higher than it was on New Years Day.
Now, let’s review some timely economic and geopolitical considerations.
While all talk of Chinese trade wars has everyone in a tizzy, recent economic data has been a mixed bag. July retails sales were excellent. Small business optimism remains positive. But August first-time unemployment claims were higher than expected. And while manufacturing was up in the New York region (Empire State Index), it was lower in the recent Philly Fed Survey. Leaving Bulls and Bears in an epic tug of war.
Speaking of China, the Hong Kong situation merits scrutiny. As it will serve as a litmus test for what China will and will not tolerate from its provincial regions in the years ahead. Moreover, Hong Kong’s protesters are standing up to the same Chinese promise-breaking and lawlessness that the U.S. is challenging through trade negotiations.
All of which begs the question: who needs a deal more?
The Trump administration faces a re-election contest in 14 months. The juice provided by a Chinese trade deal — politically and economically — would surely expedite the success of that effort. But, the administration has made it clear that it intends to rectify longstanding grievances that will level the playing field for all nations engaged in international trade. And the rewards for doing so, that is, essentially saving and preserving the current global trading order, would be immense.
China also faces a dichotomy as to where its trade interests lay.
After gaining entrance into the World Trade Organization in 2001, the Chinese proceeded to play by an entirely different set of rules than those set by the established framework. Forcing foreign companies to sell partial stakes to Chinese ownership as a prerequisite for accessing Chinese markets. Stealing hundreds of billions in foreign intellectual property year after year as part of a calculated plan to expedite Chinese technology access and competitiveness. While manipulating its currency in order to win increasingly larger shares of global manufacturing efforts.
Newton’s First Law states that an object in motion stays in motion until acted upon by an outside force. Which is to say, the longer something remains in place, the harder it becomes to change. Today’s efforts on behalf of the current global trading system will set the stage for what become permissible commerce practices moving forward. And allowing one member of that community — albeit an increasingly larger and more important member — to manipulate the system to suit its own ends will only embolden other nations to do likewise.
This leaves China’s Xi Jingping with choices. Two of which stand out.
He can play the long game. Wait 14 months, and see if Trump wins reelection. And then commit to a trade agreement. The risk being that China’s deteriorating economic prospects worsen, forcing an existential crisis upon the Chinese Communist Party as it strains to raise living standards for its huge population. Imagine the current unrest in Hong Kong playing out across the Chinese hinterlands. Not a situation Xi covets.
Or, Xi could attempt to force something through this year. Endeavor to water it down enough so as to lack teeth where enforcement mechanisms are concerned. This would buoy China’s domestic economy. And provide leeway to patiently contend with other pressing concerns. The impediment to this path being that China places the health and survival of the communist party above all else. Making it willing to take very unpopular stands for periods that most western governments could not tolerate — recall Tiananmen Square — in order to ensure its prime directive. Survival.
People and institutions rarely embrace real change unless they believe they’re going to go broke or die. Why should China’s Communist Party be different?
Barring the resolution of these grand geopolitical chess matches, the market’s upward trendline remains intact, though under pressure.
U.S. equities appear to be underpricing the risks of inflation, corporate margin compression and a slowdown in capital spending. Uncertainty surrounding the Fed’s next move could also weigh on markets. And the Fed’s next meeting isn’t until mid-September.
The S&P 500 sits 3.3 percent lower than its July 26 high. The Nasdaq has fallen 6.8 percent. The Dow is -7 percent off its July 16 high. More importantly, the Dow sits two percent beneath its high mark set in January 2018. Which represents the start of the U.S. “trade war” vs. China. Whatever other yield curves and economic data and earnings reports the market may encounter, without significant progress on the trade war and tariff front, that market ceiling could remain in place for the time being. Which means that the consolidation pattern in which equities have resided since January 2018 might continue until a catalyst throws open the barn door and lets the horses out.
Same thing occurred when markets consolidated for two years between November 2014 and November 2016. And then markets careened higher for the next three years. For now? We expect markets to remain volatile. With downside pressure interrupted by brief recovery rallies. August has seen stocks move lower in seven of the last eight years. Why would this year be any different?
Bottom line? Trying to predict the market’s next move is like trying to circumcise a mosquito. Impossible. So, we’re identifying businesses we’d like to own in addition to those we own today. And accumulating positions in both as pullbacks provide opportunities. Understanding that there will likely be more downside risk before markets eventually stabilize and move higher.
We do not believe the market’s upward trendline has run its course. For ten years, every bout of volatility has brought the Bears out of the woods, shouting about how the uptrend was finished. And every time the market regrouped and moved higher. So until we have substantive evidence leading us to conclude otherwise, we’ll believe that this consolidation period will likely lead to new highs.
Unlike previous years, however, the environment going forward will be a stock picker’s market. Not one in which you can simply buy broad indexes and watch them run up. Promising individual stocks in well-positioned industries will separate from the lion’s share of stocks comprising the larger benchmark indices.
Across the pond, conservative British MP Boris Johnson won the game of thrones to succeed the embattled Theresa May as the UK’s next prime minister. Perhaps the biggest compliment he received in his victory were the words of concession from Jeremy Hunt, whom he defeated to win the job:
“Throughout campaign you showed optimism, energy and unbounded confidence in our wonderful country and we need that.”
U.S. Trade Representatives released a statement that it would delay and remove items from the roughly $300 billion of Chinese imports facing 10 percent tariffs on September 1.
In the end, China will buy more U.S. agricultural products. And big companies like Apple will continue making products in China. And hopefully, China will cede to international pressure and align their trade practices with those other WTO members with whom they wish to do business.
Last week commemorated the 50th Anniversary of Woodstock, the epoch rock music event that served to define the Sixties counterculture movement, and its stand against the Vietnam war.
What began as a well-organized music festival quickly devolved into a survival saga. As event organizers were forced to move the venue right before the weekend began. Supplies of food and water were in short supply. As was a means of removing trash and refuse. It rained for seemingly three-straight days. And tickets became a moot point when attendees crashed through fences and thousands entered Max Yasgur’s 600-acre dairy farm in Bethel, New York,43 miles southwest of Woodstock. Forcing organizers to open the show to anyone who’d made the effort to get there. And making free music, in addition to free love, the order of the day.
Headliner Jimmy Hendrix’s seminal moment during which he played the Star Spangled banner was supposed to occur Sunday night. But Hendrix didn’t take the stage until 8 am Monday morning. At which point 40,000 of the 500,000 festival goers still remained.
Despite having over 500,000 people at the festival, only two people died. One of a drug overdose. The other person was sleeping beneath a tractor and was run over. But for the most part, given everything that went went haywire amidst the huge crowds gathered, it is astounding that more did not go drastically wrong. Instead, throngs of enthusiastic music lovers peacefully protested a war they did not believe in, while enjoying one of the greatest aggregations of musical talent ever assembled. And aptly capping off what became forever known as The Summer of Love.
Onward and upward…