Had you just looked at the stock market for the first time in the last several months, you may have concluded that it’s been a dull and particularly quiet stretch given that the S&P 500 is sitting at 2,834 (as of 3/29/19), just 1% above its trading level on November 8th of last year. On the contrary, following mid-November’s mild decline and early December’s bounce, fears that the U.S. economy was cratering sent the market into a rare year-end tailspin, resulting in the worst December since the Great Depression era. The 20% or more decline in the major global equity markets, however, was to be short-lived as the markets came roaring back during the first quarter.
The S&P 500 and the All Country World Index (excluding U.S.) registered returns of 13.65% and 10.31%, respectively, in the first quarter of 2019. The bond market average also delivered an impressive 2.94% in the first quarter on the heels of falling U.S. interest rates.
Despite the more than impressive first quarter recovery, investors are once again feeling uneasy about what’s to come next. Other than the potential fall-out from a hard Brexit, perhaps the most concerning development is emanating from the bond market where the inverted yield curve is flashing caution that the long-anticipated next recession may be upon us in the next 12-18 months. A recession would more than likely drive equity prices back down towards December’s lows or possibly worse.
Despite the bond market’s warning, there are also some potentially positive developments on the horizon that could perhaps push global equity markets higher the remainder of the year. Most importantly, a pending resolution to the disruptive U.S./China trade dispute as well as an improvement in the Chinese economy would go a long way towards improving bruised investor sentiment.
Given cheap absolute and relative valuation levels, non-U.S. developed and emerging markets have the most to gain should China’s economic fundamentals continue to improve. Emerging markets bonds, in particular, should also perform well given the decline in U.S. interest rates and relatively attractive emerging market bond yields.
Beware the Inversion?
Get ready to start seeing the word “inversion” a lot more in the financial news. An inverted yield curve refers to the situation where short-term interest rates exceed longer term interest rates. This phenomenon does not happen that often and has been a relatively sound precursor to past recessions. An inverted yield curve tends to lead to recessions because banks borrow at short term rates and lend out money to consumers and businesses at longer term rates. When banks’ borrowing costs exceed the interest rates they can charge for loans to credit worthy borrowers, their pace of lending slows and the economy sputters or contracts as credit becomes more scarce.
The chart below tracks the spread between short and long-term U.S. interest rates. You can see that since the early 1960’s there have only been two occasions where an inverted yield curve did not lead to a near term recession – in 1966 and 1998. Furthermore, the stock market generally registers significant declines (potentially greater than 30%) in recessionary times.
The U.S. labor market continues to underpin the economic expansion with the unemployment rate hovering just below 4%. As seen from the chart below, such a low level of unemployment has rarely been maintained for very long before recessionary conditions push it higher. The typical cycle has unemployment coming down as the economic cycle matures. Inflation picks up as the labor market tightens and asset prices rise. The Federal reserve raises interest rates to slow the economy and cool inflation. The unemployment rate rises as companies adjust their workforce to accommodate the slower rate of economic growth (or contractions) that typically occurs during a recession.
U.S. Unemployment Rate
Could this time be different? Possibly. The fact that inflation has been subdued for an extended period may support the notion that this economic expansion, which will become the longest in the post WWII environment this year, has longer to go.
As seen from the chart below, both headline and core inflation (excluding food and energy) readings continue to come in below the Fed’s 2% target rate. This is in spite of the tremendous liquidity and low interest rates that have been in place for the better part of the last decade. The Fed may have gone a bit too far with their rate increases but holding the line on additional hikes my stave off an outright contraction, especially if the U.S. economy gets some support from overseas.
A U.S. China trade deal would likely give the global equity markets something to cheer about, but actual improvement in the Chinese economy would really help the global economy get its footing.
After signs that the Chinese economy was buckling under pressure from new U.S. tariffs, the Chinese leadership began taking significant steps to stabilize their economy including injecting liquidity into the banking system and cutting banks’ reserve requirements. Recent data shows that these actions are starting to take hold.
As seen from the PMI chart below, Chinese manufacturing data rebounded to 50.8 in March following several months of deteriorating data points.
China PMI (Purchasing Managers’ Index)
According to research by CFRA, there have been 28 times since 1945 in which the S&P 500 was up in both January and then again in February. In those 28 years, the S&P 500 recorded an average 24% full-year total return. While there is no guarantee that history will repeat itself, it does suggest that there may be further room to run and that investors concerned about the inverted yield curve shouldn’t get too carried away with reducing their equity exposure below their long-term target levels.
Even so, bonds and income-oriented investment should remain in higher quality positions as insurance against negative developments from a “no-deal Brexit,” the U.S.’s failure to cut a trade deal with China, and/or further deterioration in the U.S. economy.