Volatility Abruptly Returns to Markets on Continuing Trade Worries
Volatility abruptly returned to markets as stocks finished negative for the second consecutive week. The week started on a negative note as trade tensions between the US and China escalated. On Monday, China announced it will raise tariffs on $60 billion of US goods starting June 1 in retaliation to the US imposing a tariff hike during the previous week. This sent major indices reeling over 2.5%, resulting in the largest single-day drop since January. However, as the week progressed stocks were able to erase a large portion of these losses, closing out the wild week only modestly lower.
While trade uncertainty between the US and China has increased, there has been notable progress in trade talks with other nations. The US agreed on Friday to lift tariffs on metal imports from Mexico and Canada – a major step in the ongoing renegotiation of the North American Free Trade Agreement (NAFTA). It was also announced the Trump administration will delay tariffs on automobile imports from the European Union and Japan for up to six months as it continues negotiations.
This week was another strong reminder of how important it is to stay committed to a plan and maintain a well-diversified portfolio. Even as stocks had rallied significantly so far in 2019, geopolitical uncertainties can lead to quick, sharp, and unpredictable market movements. This can make it tempting to make knee-jerk decisions. However, sticking to a strategy and maintaining a portfolio consistent with your goals and risk tolerance is imperative for long-term success. Including a broad mixture of asset classes can help with achieving more consistent long-term results, smoothing the short-term market noise and making it easier to weather these common volatility storms.
Chart of the Week
As trade and political risks rattled the markets, the S&P 500, Nasdaq, and Dow Jones Industrial Average all posted their second consecutive week of declines. This is the first time all three indices declined for two consecutive sessions since December 2018. However, as volatility returned to markets, it is important to remember returns can be normally distributed over the long-run. This means it is not unreasonable to expect some down days and weeks following a string of strong positive movement, such as what had been experienced so far in 2019.
*Chart source: Bloomberg
Broad equity markets finished the week negative as large-cap stocks fared better than small-cap stocks. S&P 500 sectors were also mixed, with defensive sectors outperforming cyclical sectors.
So far in 2019, technology and communications are the strongest performers while healthcare has been the worst performing sector.
Commodities were positive for the week as oil prices increased by 1.78% to $62.76/bl. This is the first increase in four weeks as investors started to price in tighter supply levels. After President Trump announced Iranian sanction waivers will not be renewed, the nation responded by threatening to resume nuclear enrichment and blocking off the Suez Canal if no one purchases their oil. This was followed by an act of aggression towards two Saudi Arabian tankers, sinking the oil-carrying vessels. As tensions continue to rise in the Middle East, the market is bracing for a possible supply constraint as demand remains relatively high.
Gold prices decreased by 0.72%, closing the week at $1,277.35/oz. This was a somewhat unusual move as volatility returned to markets and the metal generally performs well in this environment. However, further analysis showed the decline was warranted as the US dollar had its best week since February amid geopolitical tensions. Since gold is a US dollar-denominated safe-haven asset class, it tends to rise when stocks experience abnormal volatility and the dollar remains steady. Going into the remainder of 2019, gold has the potential to rise if tensions remain present.
The 10-year Treasury yield decreased from 2.47% to 2.39%, resulting in positive performance for traditional US bond asset classes. During the week, Treasuries experienced heightened demand as investors fled into safe-haven asset classes. The two-year note also experienced abnormal demand as investors hedged against the geopolitical risks we are currently facing. As we continue into the year, ongoing geopolitical tensions have the ability to continue to push yields lower.
High-yield bonds were negative for the week as riskier asset classes fell and credit spreads loosened. However, as long as US economic fundamentals remain healthy, higher-yielding bonds have the potential to experience further gains in the long-run as the risk of default is still moderately low.
Asset class indices are positive so far in 2019, with small-cap US stocks leading the way and traditional US bonds lagging behind.
Lesson to be Learned
Many people watch the prices of stocks they have recently sold more closely than the prices of those they still own; thus they show themselves to be more concerned with justifying past actions than in planning future ones”
– John Brooks
Hindsight bias leads us to believe an event was more predictable than it actually was. Unfortunately, this is an easy trap for many investors to fall into, reliving how they would have “acted differently” now knowing the circumstances of today. We need to be careful when evaluating how past events actually impact current market conditions. The past cannot be changed, but we still have the ability to adhere to a smart investment strategy and make our portfolio better in the future. Removing emotions from the investment process can help us avoid biases like hindsight, keeping us focused on what really matters – our plan moving forward.
Our investment team has two simple indicators we share that help you see how the economy is doing (we call this the Recession Probability Index, or RPI), as well as if the US Stock Market is strong (bull) or weak (bear).
In a nutshell, we want the RPI to be low on the scale of 1 to 100. For the US Equity Bull/Bear indicator, we want it to read least 66.67% bullish. When those two things occur, our research shows market performance is strongest and least volatile.
The Recession Probability Index (RPI) has a current reading of 29.29, forecasting further economic growth and not warning of a recession at this time. The Bull/Bear indicator is currently 66.67% bullish – 33.33% bearish, meaning the indicator shows there is a slightly higher than average likelihood of stock market increases in the near term (within the next 18 months).
The Week Ahead
In a relatively light week of economic reports, investors will continue to closely watch how the most recent escalation in the trade dispute between the US and China plays out.