It was another roller-coaster ride of a week; one in which the most recent of market stress seemed to be attempting to mend. In fact, until Friday, the market was up a little more than 1% and the VIX, a widely watched measure of market volatility was beginning to appear calm. Investors appeared optimistic that Fed Chair Jay Powell would deliver a dovish and re-assuring tone during his speech in Jackson Hole, WY. In fact, most believe he delivered what the market was looking for: a conciliatory tone acknowledging that global economic conditions have continued to weaken since the late-July cut and monetary policy increasingly looks out of sync with the global situation specifically citing escalating trade friction.
If you watch the news today, it is almost certain you will learn the yield curve inverted (the 2yr/10yr spread) this morning for the first time since 2007. This will probably result in a challenging market experience today (and perhaps days ahead). You will also hear inversion – a condition where short term interest rates are higher than longer term rates – is significant because it sports a strong track record for correctly signaling that an economic recession develops at some point in the not distant future. With the curve flattening for the better part of 18 months, and some maturities first inverting earlier this year, we’ve discussed why we too believe the curve slope is relevant and worth monitoring. We do not dismiss the condition as insignificant; it signals that a policy mistake is being made and damage to the economy is building. It is evidence that monetary policy is too tight for the current economic situation as a whole and will become restrictive. The ongoing friction between the US and China over trade is part of that restrictive cocktail, and the Fed should not delay in responding further via additional rate cuts in the months ahead.
Almost as quick as the calendar flipped to August, the market’s backdrop and investor sentiment was altered. Just two weeks ago, the Fed made good on months of more dovish rhetoric by cutting its target for short-term interest rates by a quarter of one percent (25 bps). While some watchers were pining for a more aggressive move, the adjustment seemed all that was warranted given a stock market near all-time highs, low levels of unemployment, and trade talks between the US and China that were reportedly making progress following a late-June G20 meeting between Trump and Xi. But with a newspaper article and harsh tweet from Trump that fresh additional tariffs would be levied against China, the Fed’s easing move suddenly felt inadequate and behind the curve. Tensions between the US and China are again heightened, and some are calling the process of negotiation all but collapsed as China allowed their currency to depreciate in retaliation and appears to be slow-walking/stalling the process. They in no way seem urgent to strike a deal even as their economy is showing signs of stress as a result of tariffs. Chinese leaders instead appear of the perspective that in the “long-game”, a weakened global and US economy hurts Trump’s chance of re-election in 2020 – and their odds of a more favorable “deal” are higher when considering the stated positions of Democratic party hopefuls.
It’s pretty easy to hear the same investment theme these days “as many investors go to the same dinner”; hear the same story; and drink the same Kool-Aid. The huge world of investible assets is quickly shrunk down to just a few of the same companies owned by many. But years of tepid economic expansion and low returns cause many investors to be hesitant to broaden their holdings beyond the few stocks delivering eye-catching results. This includes index ETFs (passive strategies) that own outsize exposure to the same fast growing companies. Even today as global growth is slow there is caution to invest otherwise despite a record widening valuation gap between growth and value stocks. Additionally, money flows are more concentrated and could exasperate market volatility and drawdown for these heavily owned exposures. Did you know, the FAANG stocks provided 25% of the YTD2019 return for the S&P500? [FAANG stocks = Facebook, Apple, Amazon, Netflix and Alphabet’s Google] Together they are a large portion of the S&P500’s total market capitalization, and their growth sizzled in recent years. Yet caution is warranted as they are priced to “perfection” – requiring close awareness to their rich valuations and being widely owned.