07 Dec 2018 What Are the Markets Telling Us?

Markets are in a tizzy (a state of nervous excitement or agitation). Investors are asking, is the party over, is the bull market ending or are we just taking a pause? The latest volatility has been set off by ‘tariff-tweets,’ Fed talk, economic data, and the arrest of a Chinese CEO during trade talks. As global markets are mind-numbingly complex, the answer is definitely all of the above, and a lot more. But market catalysts pop and fizzle with short lives, the more important questions are what do the signs tell us will happen in the mid-term and the long-term with the economy and hence, the markets?

Stocks are still up modestly for the year, when dividends are included. Bonds as measured by the 7-10 year US Treasury index are down only .74%, after being down as much as 4% twice this year. Economic and earnings uncertainty have driven skittish investors into the safety of bonds, with an emphasis on Treasurys.

Stock markets are better indicators of investor’s short-term projections, even their emotions regarding the economy and corporate earnings, while bond investors take a substantially longer view. So we do well to pay attention.

There’s been a lot of talk lately on the news about an ‘inverted yield curve.’ So what is that about and what does it suggest for our future? Turns out, an inverted yield curve is a pretty good indicator of economic downturns, predicting most of the US’s recessions in the modern era.

A typical yield curve (in blue above) is an upwardly sloping line indicating that bond yields or interest paid (US Treasury in this case) rises with maturity. For instance, a two-year Treasury yielded 1.75% last year and the ten-year Treasury yielded 2.4%, or .65% more.

An inverted yield occurs when the line ‘inverts,’ generally speaking, long-term rates are lower than short-term rates. Today the focus is on the 2-year vs. the 10-year. The difference or ‘spread’ between the two is only .14% as compared to last year’s .65%, very close to becoming zero or lower, or inverting.

A normally rising yield curve reflects higher rates partly because investors factor in a cushion for the possibility of inflation or rising prices. When investors fear inflation they demand higher returns on their bonds to offset the threat of reduced purchasing power on those dollars they will not receive for years to come on 10, 20, and 30-year bonds.

When bond prices rise, particularly for long-term bonds (i.e the 10-year) and their yields or interest rates fall, as we’ve seen recently, bondholders are telling us they don’t fear inflation in the out years because they don’t believe the economy will overheat and it may even slow.

We are seeing the opposite effect on short-term bonds. Price for the two-year Treasury is up a full 1% from last year as the Federal Reserve has been pushing rates higher to keep economic growth from going so fast that it outstrips the supply of resources and labor, driving up prices fast enough to cause inflation. Their challenge is to avoid braking too fast, sending the economy into recession.

With the combined effect of tariffs, talk with China getting tough, and global economies slowing, both stock and bond investors are signalling their skepticism, if not outright fear that the economy could turn down.

But other measures suggest a more positive outlook, at least for now. The labor market continues strong as indicated by today’s jobs report. While a bit below expectations, the economy created 155,000 jobs last month, the unemployment rate held steady at 3.7%, and wage growth matched October’s 3.1% total, the best rate since 2009, according to the Wall Street Journal. Steady wages also take some pressure off the Fed to raise rates.

The stock and bond markets are sending some strong signals for economic weakness, but they are doing so against the backdrop of one of the strongest economies the US has ever had. Tariffs can be removed by the president and interest rates can be dropped by the Fed if things get worse. Let’s remember that none of these indicators operates in a vacuum and none among us knows the future as clearly as many in the media claim.

What we do take comfort in, is that the smart men and women comprising companies all over the world find ways to make profits whether in good economies or in bad, and Treasurys dampen the bumps along the way. The combination results in a ride for our clients’ portfolios much smoother than that of the noisy, sometimes crazy Dow Jones Industrials or S&P 500. Take a look at how our models perform over time compared to the indexes driving them. Notice that in the ‘Last 10 Yrs’ column that higher risk has not yielded significantly higher returns. Why endure the heartaches?

If you are uncomfortable with today’s risk and uncertainty, please give us a call.