After a 20% or so downward slide in U.S. equities indices during the 4th quarter of 2018, the beginning of 2019 has been much kinder to equity investors. The S&P 500, which you can see in the 1-year chart below, fell swiftly from a September 2018 high of 2940 to a December 2018 low of 2346 – a drop of 20.2%. Since the beginning of the year, however, this same index is up 13.5%. Other major U.S. equity indices, like the NASDAQ and the Dow Jones Industrial Average, experienced similar downward moves during the 4th quarter of last year and rebounds so far this year.
Fixed income, on the other hand, has experienced a slide in yields since early November 2018. As you can see in the chart below of the 30-year treasury, the yield topped out at 3.46% in early November and now sits at 2.86% on 3/22/19 – a 17% drop.
The U.S. Treasury Yield Curve chart below further illustrates what has been happening with bond yields over the past year. The orange line depicts the yield curve from a year ago. Although the yields were still at historically low levels a year ago, the shape of the orange curve looks fairly “normal.” In other words, the shorter term bonds yield less and the longer term bonds yield more. This is as you would expect given that the longer term bonds inherently bear more interest rate risk than the shorter term bonds. The only thing possibly unusual about the orange line is that the slope of the curve is relatively flat between 10 and 30 years. This means that investors in the longer term bonds will not receive much additional reward in the form of enhanced yield for taking on additional years of interest rate risk.
The blue line depicts the yield curve in mid-March 2019. The “Target” on the curve went from 1.50% a year ago to 2.50% now. The Target is the federal funds rate and the Federal Reserve increased this rate by 1% over the last twelve months. As you can see on the blue line, some of the longer term treasuries are yielding less than some of the nearer terms bonds. For example, the 1-year bond currently yields more than the 2-year, the 3-year, and the 5-year bonds. This is called an inverted yield curve and is of some concern as prolonged periods of inversion are considered a decent predictor of a recession in the coming year or two.
On the one hand, the U.S. bond market appears to suggest that a recession, or at the very least a period of slower economic growth, might be in the offing in the not too distant future. U.S. equity markets, on the other hand, seem to be more optimistic. A hint of this dichotomy was also evident in the Federal Reserve’s March 20th press release in which it identified some of the mixed-message economic data of late and announced that it would continue to hold the federal funds target rate at 2.25 – 2.50%. In particular, the press release stated:
the labor market remains strong but that growth of economic activity has slowed from its solid rate in the fourth quarter….[r]ecent indicators point to slower growth of household spending and business fixed investment in the first quarter….[t]he Committee continues to view sustained ex- pansion of economic activity, strong labor market conditions, and inflation near the Committee’s symmetric 2 percent objective as the most likely outcomes.
Probably the most interesting or telling portions of Fed Chairman Powell’s recent pronouncements related to the March 20th monetary policy decisions are:
- The Fed is likely on hold with the fed funds rate for the remainder of this year – in other words it is quite possible there will be no more interest rate increases in 2019. This is quite different from the Fed’s December statement in which it predicted implementing 1 – 2 interest rate increases this year.
- The Fed will immediately begin slowing the program it initiated in September 2017 to reduce its aggregate securities holdings. Since that time, the Fed has been allowing about $30 billion in Treasury bonds to roll off each month without replacing them. This slowly and steadily caused the Fed’s balance sheet to shrink by $487 billion. This sounds impres- sive but the balance sheet is still $3.9 trillion – almost 5 times greater than where it stood (around $800 billion) at the beginning of the financial crisis. Starting in May, the Fed will allow a maximum of just $15 billion in treasuries to mature without replacement and then will conclude this reduction program in September.
U.S. and global financial markets will continue to closely watch what the Fed and its central bank counterparts around the world do this year, particularly in light of the slowing global growth trend which is partially due to the China-U.S. trade dispute and the many uncertainties surrounding Brexit. In Europe, the EU recently announced it will implement additional stimulus efforts to help buoy flagging growth and will keep its key interest rate at -0.4% (yes that is a negative interest rate!).
In addition to some uncertainties around central bank monetary policies, other key issues impacting financial markets at the moment include the recent drop in the U.S. inflation rate, slowing global growth, ongoing trade disputes and tariffs, and Brexit. For now, there is a slight reprieve on Brexit as the EU just agreed to extend the Brexit deadline from March 29 to May 22 provided the UK approves a Brexit withdrawal agreement next week or otherwise advises the EU by April 12th how it plans to proceed with moving the Brexit process forward. This is a very fluid situation and it is unclear at this point whether Prime Minister May will even have sufficient support to push her Brexit plan through Parliament next week – something she has already failed to do several times – and what will happen next if she doesn’t.
There is also growing concern that the Fed was never able to fully normalize the fed funds rate or its balance sheet before reaching a point where another patch of slowing economic growth might eventually need some attention – i.e. stimulus. The effective fed funds rate is currently 2.4% but the long term average is 4.81%. The historical fed funds rate chart below puts in perspective just how low rates still are despite several years of rising rates.
Already, some economists and Fed-watchers are wondering whether the Fed will have the necessary firepower to stimulate the U.S. economy, if or when necessary, since it won’t be starting that fight at full strength.
Finally, there is some concern related to the economic slowdown that has spread around the globe. A number of economies heavily reliant upon exports and global manufacturing are already feeling the painful pinch of heightened tariffs coming out of the ongoing U.S./China trade dispute. This is unfortunately occurring at a time when a number of economies, including those in Europe, Asia, and the U.S. are gradually slowing. The International Monetary Fund recently slightly reduced its global growth prediction to 3.5% from 3.7%. While there does not appear to be any major concerns that the U.S. or other major world economies are imminently heading into a deep recession, most economists and investors are closely watching economic data releases to ascertain whether we are just in a period of slower economic growth or whether a more serious trend may be developing.
At this point, we are mindful that some economic data is trending slightly negative and recognize there are some major uncertainties weighing on financial markets. Of course, these could change at a moment’s notice – the trade war with China or the Brexit situation could resolve and that would greatly improve sentiment and ease uncertainty. But, we certainly cannot predict if or when any such resolution(s) may or may not be reached. A well-diversified portfolio should provide some protection if we end up in a period of volatile markets.