Market analysts love their metaphors because they help put very complicated issues into a clearer context. Liz Ann Sonders, Schwab’s chief market strategist, is no different. In her recent piece she and her team even quote from Louisa May Alcott’s Little Women, “I’m not afraid of storms, for I’m learning how to sail my ship”, to set the stage for their outlook: pleasant skies overhead with storm clouds on the horizon.
Being a bit of an armchair sailor myself, these “looming storm” metaphors resonate with me. Like we’ve discussed previously, there are a growing number of indicators signaling a coming recession, but if you look around today you probably won’t see them. As the article below indicates, consumers are still out there buying. Wages have been rising so much of this buying has been with cash versus credit. More workers are feeling comfortable enough to consider quitting their job for a better one. Businesses are reporting solid profits. Interest rates are at record lows. In general, the list of positives is long.
But the negatives, or the storm clouds on the horizon, are building. Eventually, also as the article indicates, we’ll be in a recession anyway because it’s simply part of the economic cycle. When will it happen and how bad will it be? Will it sink your ship or merely help you be a better sailor? Time will tell. In the meantime, check out the following excerpts for Liz Ann’s take on our position (emphasis mine).
The theme to our 2019 outlook was “be prepared” and we continue to see some clouds forming on the horizon.
Aside from trade/tariff volleys (if only we could move aside from trade news), the latest concern has been the inversion of the 10-year/2-year Treasury yield curve. As you can see below—similar to the 10-year/3-month curve that first inverted in March—the 10-year/2-year inversion has preceded every recession since the 1960s. However, there were two periods—in 1966 and 1998—when the yield curve inverted, but a recession remained a fair distance away.
Recessions are inevitable and occur at the end of every economic cycle, so the U.S. economy is sure to have one. The unknown factor is the amount of time until it arrives, as the lead time from inversion until recession is highly variable:
- The median span from an inversion in the 10y-3m curve and recessions historically was 12 months—with a range of five to 23 months.
- The median S&P 500 performance during those spans was 4.2%—with a range of -16.6% to +22.8%.
- The median span from an inversion in the 10y-2y curve and recessions historically was 17 months—with a range of 10 to 24 months.
- The median S&P 500 performance during those spans was 4.4%—with a range of -12.0% to +30.0%.
- Of course, past performance is no guarantee of future results, but importantly, the ranges show that there is little consistency historically in terms of recessions’ timing or stock market performance in the aftermath of inversions in the yield curve.
Various pundits have dismissed both yield curves’ inversions this time around, citing the unique circumstance around why the curve inverted this year. Being mindful of the daring use of the phrase “it’s different this time,” the reality is that every cycle is unique in nature. This time around, the phenomenon of $17 trillion of negative-yielding global debt (Wall Street Journal) is certainly novel—and has undoubtedly led to significant safe-haven/higher-yielding purchases of longer-term Treasury securities. As such, unlike most past episodes, the curve inverted this time because long yields fell below shorter-term yields vs. the Fed raising short-term rates above long-term yields. That said, an inverted yield curve, when persistent (and regardless of why/how it inverted), does crimp or eliminate the spread banks can earn by borrowing short and lending long—typically constraining credit availability, a common precursor to recessions.
Due to the latest tariff escalations; and limited incentive for either side to compromise at this stage, we see little prospect of a resolution in the near future. Barring some minor positive developments, the general rhetoric over the past couple of months has shown no evidence of a conciliatory tone. The tit for tat continues, and the longer the dispute and escalations continue, the more damage it is likely to do to corporate animal spirits and capital spending intentions. The prospective risk is that manufacturing’s weakness starts to bleed into the consumer/services side of the economy. This may already be underway, with the latest services purchasing managers index (PMI) from Markit falling to 50.9 (which is barely above the 50 mark denoting expansion). The slide coincided with a weaker manufacturing reading, which did dip to slightly below the 50 line. This weakness into services could be exacerbated by the fact that the next two rounds of tariffs on Chinese imports are a direct hit to consumer goods.
For now, the U.S. consumer is chugging along. Retail sales in July surprised to the upside with a robust reading of 0.7% month-over-month while, excluding the more volatile autos and gas components, sales increased 0.9% month/month and 4.2% year/year. Consumer confidence remains solid due to wages trending higher and jobless claims sitting at historically-low levels.
[The] Fed appears to be more focused on the consumer’s strength in holding up the economy. The July Federal Open Market Committee Meeting (FOMC) minutes reiterated what Fed Chairman Jerome Powell noted immediately following the FOMC meeting last month—that the July rate cut was a “mid-cycle adjustment” rather than a “pre-set course” for an easing cycle. Yet, despite that, investors are still pricing in at least two more cuts this year. The divergence between these expectations and the Fed’s signaling will have to be resolved at some point, and market volatility could increase along with convergence.
While manufacturing continues to weaken and the U.S.-China trade dispute shows no sign of a resolution, the U.S. consumer continues to power the economy thanks to positive wage growth and a tight labor market. However, it’s prudent to be prepared for more bouts of volatility, and investors should make sure they are keeping a diversified portfolio with equity exposure equal to their risk tolerance. We don’t recommend trying to trade around short-term moves, but rather focusing on the long-term, remaining disciplined, and using bouts of volatility as opportunities to rebalance.
Here's a link to the full article if you’d like to read more:
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