Volatility Continues as Widely Watched Yield Curve Inverts
Major US stock markets finished negative for the third consecutive week as bond yields continued to plunge. Wednesday was particularly negative as stock indices fell around 3% following a yield curve inversion – when longer-term Treasury yields fall below shorter-term Treasury yields. Though there had been partial yield curve inversions earlier in the year, the most widely followed benchmark for this (the 2-year and 10-year Treasury yields) officially inverted for the first time since December 2005.
Typically, an inversion of this part of the yield curve is seen as a recession indicator as it has preceded every recession over the past 50 years. However, it is important to keep things in perspective as the exact timing of a potential future recession cannot be easily gathered. For the last five yield curve inversions (starting in 1978), there has been an average of 17 months until the start of a recession. The average return for the S&P 500 during this lag period was a gain of 15%, (with only the dot-com bubble burst in the early 2000s showing a negative return). This illustrates that while the economy is likely in the late stages of expansion, the recent yield curve inversion is NOT predicting an immediate recession or market crash
Despite the drubbing on Wednesday, stocks moved higher on Thursday and Friday to minimize the damage for the week. Helping recoup some of the losses, the US decided to delay some of the most recently announced China tariffs until December. President Trump confirmed the two countries will hold talks next month. Furthermore, economists raised their forecasts for Q3 GDP growth and recent data illustrates the US economy remains relatively healthy, helping alleviate investor concern of a looming recession.
Recent weeks have been a great example of why it is so important to remain committed to a long-term plan and maintain a well-diversified portfolio. While stocks trended lower, other asset classes continued to perform well as gold, REITs, and US Treasury bonds all experienced gains. Flashy news headlines can make it tempting to make knee-jerk decisions, but sticking to a strategy and maintaining a portfolio consistent with your goals and risk tolerance can lead to smoother returns and a better probability for long-term success.
Chart of the Week
All three major US indices posted their third consecutive week of negative returns. This is the second-longest stretch of weekly negative returns this year. A similar pattern was last seen in May after indices secured all-time highs and retreated for four consecutive weeks. Although the S&P and Dow Jones continued to advance in the second half of last week, returns were not enough to erase losses. Markets typically pullback after a period of strong momentum as prices tend to return to a more sustainable long-term average.
*Chart source: Bloomberg
Broad equity markets finished the week negative as tensions rippled through stocks, both domestically and internationally.
S&P 500 sectors were mostly negative, with defensive sectors outperforming cyclical sectors. So far in 2019, technology and real estate stocks are the strongest performers while energy has been the worst-performing sector.
Commodities were negative for the week though oil prices increased 0.68%. Despite some downward pressure mid-week due to recession concerns, oil rose by weeks-end on the back of hopes of additional stimulus from the Central Bank. Additionally, the Organization of the Petroleum Exporting Countries (OPEC) cut its outlook on global oil demand for the remainder of 2019 quoting slow economic growth. OPEC is the second organization to cut its forecast due to global growth concerns this year. Year-to-date, oil prices are up 23% but are still 15% below the highs experienced in April.
Gold prices rose by 1.00%, closing the week at $1,523.60/oz. This is the third consecutive weekly increase and the second week Gold has successfully maintained momentum above the $1,500/oz level. Gold has risen over 16% on a year-to-date basis as investors have been picking up the metal in efforts to hedge against market volatility. Additionally, since gold is US dollar-denominated, it tends to perform best when interest rates are low and prospects of further cuts are strong – precisely the current environment we are in. As the metal continues to rise, it sits at a 6-year high.
The 10-year Treasury yield fell from 1.74% to 1.55%, resulting in positive performance for traditional US bond asset classes. Yields hit the lowest level since September 2016 as trade fears rippled through markets. Additionally, during the week, the 10-year to 2-year yield curve inverted. This happened as investors rushed into longer-term treasuries on the back of increasing geopolitical risks. Historically, the inversion of the 10 and 2-year yield curve has preceded recessions. However, this is not predicting an immediate recession or market correction.
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 large-cap US stocks leading the way and commodities lagging.
Lesson to be Learned
Games are won by players who focus on the playing field — not by those whose eyes are glued to the scoreboard.”
– Warren Buffett
Too often, investors get caught up in the daily values of their portfolios. During periods of heightened volatility, it can be especially tempting to make knee-jerk decisions in reaction to recent market movements. However, if you are too focused on short-term results it can come at the detriment of long-term gains. This is why it is important to implement a plan with predefined steps to take ahead of time. If you stick with a plan and maintain a properly diversified portfolio, you increase your chances for a successful investment outcome in the long-run.
FormulaFolios 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 28.76, forecasting further economic growth and not warning of a recession at this time. The Bull/Bear indicator is currently 100% bullish – 0% 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 data releases, investors will be watching to see how markets react to the recent increases in volatility and geopolitical uncertainty.