Week in Review
Following the strongest week of 2018, global stocks experienced sharp losses as major headlines drove volatility higher.
The week started on positive footing as it was announced the US and China agreed to a temporary trade truce, halting new tariffs for 90 days as the two countries continue negotiations.
However, the good news was short-lived as a partial yield curve inversion spooked investors, with the yield of 3-year Treasury notes surpassing the yield of 5-year Treasury notes. This sent major US indices down over 3% on Tuesday – the fifth such occurrence of a 3% of larger daily drop in 2018. While no indicator is perfect, yield curve inversions are typically seen as a warning signal for higher recession risk, though the “big one” to watch is the 2-year and 10-year Treasury yield spread (which remains positive as of now).
Markets were closed on Wednesday for a National Day of Mourning for former President George H.W. Bush, but global stocks continued to plummet Thursday morning with the Dow Jones Industrial Average falling another 3% mid-day. The continued sell-off came on the back of Huawei CFO Meng Wanzhou’s arrest in Canada, where she faces extradition to the US for allegedly violating Iran sanctions. Huawei, a Chinese telecommunications equipment company, is one of the largest mobile phone makers in the world, and the arrest of Wanzhou instilled doubt a permanent US-China trade deal will be reached as this could cause more geopolitical stress between the countries.
As it seemed markets were headed for the worst week of 2018, major indices rallied off their low levels late Thursday afternoon and closed the day mostly unchanged after Federal Reserve officials signaled they may take a “wait-and-see” approach following another rate hike in December. Investors took this as positive news indicating the Fed is wary of disrupting the stability of financial markets. Lower rates are seen as more accommodative for further economic growth, so a potential “pause” in future rate hikes provided relief to the growing concerns of a slowdown.
When all was said and done, major indices ended the week with sharp losses as a weaker-than-expected jobs report and continued trade tensions sent markets lower on Friday. Markets have been particularly sensitive to headlines in recent weeks, making it difficult to navigate through the heightened levels of volatility. However, as long as the economy remains healthy and earnings continue to grow, there is the potential for further market gains (though many expect volatility to persist in the foreseeable future). While short-term trends and market noise can make it tempting to make knee-jerk decisions, 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
Similar to 2015-2016, the S&P 500 has experienced two 10% corrections within the past year. In both instances, markets experienced prolonged periods of volatility, followed by a recovery, only to be hit with more volatility. However, while the technicals are showing similar patterns to 2015, the underlying fundamentals are different. In 2015, earnings were trending negative and market fundamentals were deteriorating. In 2018, it seems markets have been affected by rising interest rates, inverting (or close to) yield curves, and trade tensions – more geopolitical issues than fundamental. Furthermore, tax cuts have provided stimulus at a time of quantitative tightening, helping support a potential continuation in the bull market. While the chart patterns look relatively similar, the underlying reasons behind the 2018 corrections are quite different than 2015.
*Chart source: Bloomberg
Broad equity markets finished the week negative as small-cap US stocks experienced the largest losses. S&P 500 sectors were mostly negative, with defensive sectors outperforming cyclical sectors.
So far in 2018 healthcare, utilities, and consumer discretionary are the strongest performers while materials and communication services have been the worst performing sectors.
Commodities were positive as oil prices increased by 3.30%. This is the second consecutive weekly gain after falling over 22% from recent high levels. Crude settled at $52.61/bbl after the OPEC group reached a deal along with their allies to cut production. The agreement entails lowering output for the first 6 months of 2019 by 800,000 barrels per day (bpd). Russia alone will be reducing production by an additional 400,000 bpd, bringing the combined cut to 1.2 million bpd. The new agreement was long awaited after sanctions on Iran seemed to not affect oil supply and drove prices to their worst level in over a year. Going into the meeting, commodity watchers expected an estimated cut of 1-1.4 million bpd bringing the cut within estimates. One analyst estimates the cut will bring crude back up to $70 a barrel by the third quarter of 2019.
Gold prices rose by 2.17%, closing the week at $1,252.60/oz. The metal hit a 5-month high as the dollar weakened on the back of a weaker-than-expected jobs report. Additionally, recent fed comments have had a dovish tone, leading investors to believe there might be fewer rate hikes than originally expected in 2019. Gold, often viewed as a safe-haven asset class, typically performs better in low and steady US interest rate environments as foreign investors don’t have to pay a premium for the metal. Following the recent bout of market volatility in domestic and global stock markets, the metal has become a more attractive avenue to hedge risk.
The 10-year Treasury yield fell from 3.01% to 2.85%, resulting in positive performance for traditional US bond asset classes. The fall in stock markets lead investors into treasuries, pushing yields lower. Additionally, as risks mount, the Fed seems to be presenting a more dovish tone in recent speeches. Current probabilities for a rate hike either in December or January are 73.2% and 70.7% respectively. In the upcoming weeks, investors will be watching geopolitical and market events in order to gauge the need for safe haven treasuries.
High-yield bonds were negative for the week as riskier asset classes performed poorly and credit spreads loosened. However, as long as economic fundamentals remain healthy, higher-yielding bonds are expected to continue outperforming traditional bonds in the long-run as the risk of default is moderately low.
Asset class indices are mostly negative so far in 2018, with large-cap US stocks leading the way and international stocks lagging behind.
Lesson to be learned
A lot of people with high IQs are terrible investors because they’ve got terrible temperaments. You need to keep raw, irrational emotion under control.”
– Charlie Munger
While intelligence is important for creating an investment strategy, many investors struggle with keeping emotions intact. It can be easy to get caught-up in short-term market movements, letting emotions drive the decision-making process and deviating from the plan. However, this is often when investors make the worst financial decisions, causing the most harm to their portfolios. By staying disciplined and sticking to an emotion-free investment strategy, you can avoid irrational missteps and increase the odds of success in the long-term.
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 24.46, forecasting further economic growth and not warning of a recession at this time. The Bull/Bear indicator is currently 100% bearish, meaning the indicator shows there is a slightly higher than average likelihood of stock market decreases in the near term (within the next 18 months).
The Week Ahead
In a light week on the data-front, investors will be watching to see how markets react following the recent spike in volatility.
More to come soon. Stay tuned.
Derek Prusa, CFA, CFP®
Senior Market Analyst