Week in Review
Stocks closed lower for the week as global growth fears resulted in a sharp Friday sell-off, causing a partial yield curve inversion.
Markets started the week on a mostly positive note as the S&P 500 was able to hold above the key resistance level of 2,800. Helping boost gains, the Federal Reserve kept interest rates unchanged and indicated it is unlikely to raise rates in 2019 unless conditions change significantly. This is a major shift as the central bank anticipated two rate hikes would be appropriate going into the year. The Fed also stated it would conclude its balance sheet unwinding at the end of September, signaling another move to keep interest rates suppressed. Investors cheered this dovish Fed stance, sending US stocks higher through Thursday.
However, weak German manufacturing data caused a global sell-off on Friday. The Germany Manufacturing Purchasing Managers’ Index plunged to 44.7, marking its lowest reading since 2012. A reading below 50 represents a contraction in the manufacturing sector. As investors flocked to safe-haven asset classes, the 10-year US treasury yield fell sharply, dropping below the 3-month yield for the first time since 2007 (this is known as a partial yield curve inversion). Typically, a yield curve inversion is seen as a recession predictor.
While this is newsworthy, 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. Furthermore, some economists have noted that significant central bank intervention since the 2008 financial crisis may be making the signal less reliable as longer-term rates have been artificially held down.
Despite the negative finish to the week, stocks have rallied significantly since the late December lows, with the S&P 500 gaining over 19% since Christmas – bringing it within 5% of a new all-time-high. Following such a strong rally to start the year, the potential for continued gains seems to be hinging on a US-China trade deal. Trade tensions have been a constant source of volatility over the past year, but optimistic reports have boosted investor sentiment in recent months. However, there are also still reasons to remain cautious, such as softening global growth, Brexit uncertainty, and an inverted yield curve. With conflicting signals and data, it is reasonable to expect volatility to persist as markets remain sensitive to major headlines. This market noise can make it tempting to make knee-jerk decisions, but as investors we need to stay committed to our long-term financial goals and risk tolerance. Staying focused on our long-term investment objectives and maintaining a disciplined investment strategy can help reduce market noise and increase the odds of a successful outcome over time.
Chart of the Week
The spread between the 3-month and 10-year treasury bill turned negative on Friday as weak German manufacturing data had foreign investors running into safe haven Treasuries. This comes at a time when fears about a slowing global economy have begun to drive investor behavior and influence central bank policies. Typically, when the yield curve inverts (the shorter end is yielding higher than the longer end) a recession follows within 10-24 months. However, a more reliable precursor to recessions is the spread between 2-year and 10-year Treasury bonds. Currently, that spread still sits positive at 0.12%, 2 basis points above from its bull market low of 0.10%. The last negative spread was in June 2006. At that time, the central bank was aggressively hiking interest rates, causing the spread to dramatically tighten.
*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 mixed, with defensive sectors outperforming cyclical sectors.
So far in 2019, technology and real estate stocks are the strongest performers while healthcare has been the worst performing sector.
Commodities were positive as oil prices increased by 0.89% to $59.04/bl. This marks the third consecutive weekly increase for the commodity since falling to the $55/bl level a few weeks ago. Oil climbed as new data showed US crude inventories dropped the most since last June. Additionally, global sanctions on countries like Iran and Venezuela remain, further tightening supply in the market. Year-to-date, oil prices are up over 30%.
Gold prices increased by 0.72%, closing the week at $1,312.30/oz. This is the metals second week closing above the $1,300/oz level as investors remain cautiously optimistic in equity markets. Recent shaky global economic news has caused investors to hold a larger position in safe-haven asset classes. Since gold is a US dollar-denominated safe-haven asset class, it tends to perform best when interest rates are low, volatility is high, and supply and demand forces are stable. If current geopolitical tensions were to persist and economic data were to deteriorate, the demand for gold as a safe haven asset could increase.
The 10-year Treasury yield decreased sharply from 2.59% to 2.44%, resulting in positive performance for traditional US bond asset classes. This is the lowest level for yields since December 2017. Poor global economic data increased demand for US safe-haven treasuries as investors attempt to hedge risk. Additionally, possible headwinds remain as both Brexit and the US–China trade negotiations are ongoing. In the upcoming week, investors will be watching for developments in trade negotiations and monitoring global economic data to determine if a declining trend is beginning to form.
High-yield bonds were slightly positive for the week as lower interest rates offset losses in riskier asset classes. 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 commodities leading the way and traditional US bonds lagging behind.
Lesson to be Learned
You can find good reasons to scuttle your equities in every morning paper and on every broadcast of the nightly news”
– Peter Lynch
With the fast pace of technology growth and news delivery, it is easy to find reasons to “tinker” with your investments every day. However, reacting to “hot headlines” can be detrimental to your portfolio. To be a successful investor, it is imperative to be resilient and patient, removing emotions from the equation and sticking to the plan you have laid out. By sticking to an emotion-free, disciplined investment strategy, you can avoid chasing returns and increase the odds of success 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 33.40, 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
The final estimate of Q4 2018 GDP is set to be released on Thursday. Investors will also be watching to see how markets react following last Friday’s sell-off.
More to come soon. Stay tuned.
Derek Prusa, CFA, CFP®
Senior Market Analyst