Markets are continuing the Tuesday selloff on Thursday, as Wednesday evening had a number of headlines which have further exacerbated concerns within the market. The S&P 500 was very close to ~2650 as of 10AM EST, which is essentially the low level of the range that we have been trading at since early October. It appears that we are going to test that lower level of valuation support today.
Overnight, news broke that the CFO of Huawei was arrested in Canada on December 1st at the request of the United States related to charges that the company has violated US sanctions on Iran. There is obvious concern that the arrest of a high-profile Chinese citizen may derail any progress towards a trade deal towards the end of the 90 day “cease fire” that had been agreed to by China and the United States at the G20 summit in Argentina, evidenced by the strong reaction from the Chinese embassy in Canada to the news. This is a little bit of a whipsaw, as while the market was closed on Wednesday the Chinese had made a number of conciliatory gestures including indicating a willingness to negotiate, an interest in resuming purchases of US crude oil and soybeans, and some commentary around stiffer penalties for the theft of intellectual property. This continues to be a developing story, and we believe that the trade overhang volatility will be with the market for a long time to come.
The other area of concern for the market, away from trade, has been the shape of the yield curve. The yield curve refers to how much the government pays to borrow for different durations – 2 years, 3 years, 10 years, etc. Normally, you would expect them to pay more to borrow money for longer duration – it costs more to borrow for 10 years than it does for 2. Occasionally, during times of economic stress, this relationship can invert, which is typically read as a signal that the bond market is concerned about future growth prospects. Said differently, interest rates tend to follow inflation which follows growth. If growth slows dramatically, inflation falls, and interest rates follow. In a falling interest rate environment, you would rather own long duration bonds versus short duration bonds. Thus, historically, when the yield curve inverts it is an indication that the bond market may be looking for slowing growth, and there is some historical evidence to support a yield curve inversion as a 12-18 month forward predictor of recessions. The most reliable predictor in that regard is the 10 year rate minus the 2 year, which for the moment is still positive (but it’s close to flat).
There are a couple of problems with that analysis in the current period. First, the indicator has given false positives in the past (it went briefly negative in mid-1998 as an example), and the 12-18 month leading indicator issue is a broad range – sometimes it can take two or more years for a recession to show up. Second, it should not be lost on anyone that we are dealing with a highly manipulated yield curve. Government balance sheets bloated with long dated bonds in an effort to keep long term bond prices low are unique to the current cycle, and so it is a little tough to tell if the indicator will be as predictive as it has been in the past given the manipulation of the curve. Last, but not least, the indicator generally predicts slowing economic growth, but that slowing growth is widely expected – after 2018’s 3+% GDP growth which was fueled in part by tax reform, most economists are looking for the US economy to move closer to trendline in 2019.
We would also note that several recent fed comments have been relatively dovish, and while we still expect the Fed to hike short term rates by another quarter of a percent in December, it certainly seems as if the members of the Fed are paying attention to the signals being sent by the longer end of the treasury curve.
As always, please reach out with an questions or comments, and we thank you for your continued partnership.