Markets have experienced a dramatic reversal of psychology over the past month. Increased trade tensions between the U.S. and China combined with the implementation of tariffs and the announcement of surprise potential tariffs on Mexico have sent stock prices and long-term bond yields spiraling lower. As a result, the S&P 500® is down about 7% from its all-time high of late April.
Here are the key areas we believe investors need to focus on in what is now a very different environment than just a month ago.
Recession risk is once again the markets’ primary concern. Up until early May, the markets had gradually discounted the risk of recession over the next year to be close to nil. This was based in large part on a strong, first quarter GDP print, low inflation, an accommodative profile at the Federal Reserve, expectations of accelerating earnings growth in 2020, and, of course, a favorable reconciliation to the U.S.-China trade dispute with the curtailment or elimination of pending U.S. imposed tariffs. When the prospect of this trade agreement broke down and tariffs on $200 billion of Chinese goods were raised from 10% to 25% on May 10, with more certain to follow, it created a cloud over the other favorable criteria that had driven stocks to record highs.
Additional tariffs threatened on Mexico have exacerbated these fears of a slowdown. While the escalation of tariffs on China reemerged from the woodwork on May 10, the announcement of potential 5% tariffs on all Mexican goods came out of the depths of left field on May 30, catching the markets by complete surprise. Moreover, the White House rationale for these tariffs was unrelated to trade or economics but immigration, and this has further created angst within the markets. If imposed, these tariffs could increase in the coming months, and the U.S. auto industry, in particular, is believed to be positioned to take the brunt of the impact as they are large consumers of Mexican-produced parts. While these tariffs on approximately $350 billion of Mexican imports are not scheduled to take effect until June 10, it appears as though the markets are holding out little hope they will be averted. So all else being equal, this development is perceived to have added to the recently increased sense of economic uncertainty.
Long-term bond yields have plummeted and reflect concerns of economic growth. Perhaps of far greater notice than the correction pace stocks have entered in recent weeks is the decisive decline in long-term bond yields. The 10-year U.S. Treasury yield has fallen from 2.55% on May 2 to 2.07% on June 3, representing its lowest point in almost two years. This in our opinion reflects investor uncertainty about the broader markets and a flight to quality, as U.S. rates continue to have substantial premiums to other regions of the world such as Europe and Japan.
The Treasury yield curve now maintains a meaningful inversion between the 3-month and 10-year rates. With this rapid decline at the long end, there is now a noticeable downward slope in yields between the 3-month and 10-year Treasury rates of approximately 0.26% (2.33% versus 2.07%), which is also fueling the flames of recession speculation. Historically, an inverted yield curve has been viewed as a forecasting mechanism of an economic slowdown and precursor to a recession. Here we believe it is important to recognize there are reasons why the yield curve would invert other than necessarily predicting a recession, and the other widely followed slope — the 2-year versus 10-year curve — remains upward sloping.
The markets are now expecting two rate cuts by the Fed between now and year-end. Current futures markets are now discounting a better-than-even probability that the Fed will cut the Fed Funds rate at its late July meeting, followed by an additional rate cut in September or December. This of course represents a sea change of just six months when the Fed had provided guidance on two rate hikes for 2019.
With these areas of focus in mind, here are some of our thoughts:
Even with a prolonged U.S.-China trade dispute and Mexican tariffs at 5%, we do not see the U.S. economy falling into recession in the next year. Lost in the trade and tariff mania of the past month is the fact that the underlying dynamics of the U.S. economy remain strong. Unemployment is at a 50-year low, wage growth is at multi-year highs, low inflation has been helping to preserve the buying power of consumers, and while volatile, consumer spending has maintained strong annualized growth. These factors, when combined with the now expected easing at the Fed, should be enough in our opinion to avoid negative economic growth.
Unlike most other economic developments, the tariffs and trade disputes have a binary element to them. Most economic events reflect ongoing trends subject to evolving criteria. However, these tariffs — and the escalating trade hostilities they have created — are for the most part a result of human decisions and negotiations that can change on short notice. Should we see a resolution on both the China and Mexico fronts, stocks and the credit markets would likely rally toward previous highs, and bond yields would rise as well.
While we do not believe a recession is likely in the year ahead, the current trade environment reduces the probability of the Goldilocks scenario many were anticipating in the year ahead. More than anything else, we believe what moved markets during the first four months of this year was the prospect of an economy that was not too hot or too cold, perhaps in the mid-2% growth range and one that would be accompanied by low inflation, a patient and market-friendly Fed, and the potential for double-digit corporate earnings growth in 2020. For the time being, the tariffs and trade dispute have thrown cold water on this overall combination, and market prices now reflect that. In the event tariffs and trade relations are reconciled in the months ahead, Goldilocks could be back in play.
We believe the yield curve is not forecasting a recession. More than anything else, we believe the current state of the yield curve, even after accounting for the substantial decline in yields at the longer end of the Treasury curve, is not predicting a recession. In our opinion, the demand for longer-term U.S. bonds is still being mostly driven by the significant yield premiums U.S. Treasuries maintain in comparison to overseas debt. For example, amid recent global growth concerns, the Japan 10-year bond yield has fallen to a negative 0.09% (-0.09%) and the 10-year German Bund has declined to a negative 0.20% (-0.20%). Therefore, we believe it is these dramatic differentials to even the low 2% rate on the U.S. 10-year that is suppressing the longer end of the curve and contributing to the inversion. We also would like to emphasize that recessions of recent decades have also been preceded by an inverted curve on the 2-year to 10-year slope, which as we have mentioned remains positive at about 0.23% (1.84% versus 2.07%).
We would not be sellers of stocks at these lower levels in large part because, even when taking into account the impacts of the tariffs and trade disputes, there is still a path to resolution that can be readily implemented in the event both sides are willing. While the current situation may appear to be well astray from that point, we would highlight conditions can change quickly, just as they did a month ago. In addition, we believe the markets will also favorably respond to Fed rate cuts if we see them in 2H19, which we believe we will. So while the chain of events has certainly seemed negative in recent weeks, the overall mix of risks versus opportunities still appear to be on the investor’s side.
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