November 12, 2019

What a difference a year makes. Or does it? It depends on where you look.

A year ago, we wrote about markets being at all-time highs, a strong domestic economy with extremely low unemployment, growing trade protectionism, the Federal Reserve (“Fed”) moving deliberately to raise short-term borrowing rates, and few signs of a looming recession. From a stock perspective, we commented that we felt stock valuations were relatively high, especially within the technology sector.

So, What Hasn't Changed?

The domestic economy is still growing, while at a slower pace, with few signs of inflation and unemployment moving even lower. Internationally, Brexit is still unresolved and trade rhetoric continues while China and the Eurozone face worries about their own slowing domestic economies. In spite of a 15% market correction, which culminated on Christmas Eve, the market has moved 6.5% higher since September of last year, and is near all-time highs.

What Has Changed?

Trade rhetoric has intensified and stalled, causing both China and the U.S. to further escalate tariff levels. The negative impacts of these tariffs are beginning to show up in the economy. So, while the U.S. economy is still growing, manufacturing is slowing and by some measures is in a recession. The ongoing failure to successfully negotiate Brexit has ushered in a new Prime Minister and an upcoming election in the United Kingdom. Argentina now struggles to avoid yet another sovereign debt restructuring. In Washington, we are 12 months closer to the 2020 presidential election, so speculation about prospective policies has already begun.

Most notably, the perceived negative impact of these changes on the domestic economy convinced the Federal Reserve to reverse course. After increasing interest rates four times in 2018 with the aim of “normalizing” rates, thus far in 2019 the Fed has cut rates three times, with divided opinions on future cuts. Since bond prices move in the opposite direction from interest rates, this touched off the largest bond rally in a century—measured by the Bloomberg Barclays Aggregate being up 11.5% in the last twelve months as of the end of October!

“After increasing interest rates four times in 2018 with the aim of ‘normalizing’ rates, thus far in 2019 the Fed has cut rates three times, with divided opinions on future cuts.”

In terms of market valuations, by the simple measure of the price-earnings ratio, earnings estimates for the market (using the S&P 500 Index as a proxy) have come down a little; so, on average, the market still appears slightly overvalued.

What are We Talking About?

Recession Fears

Many point to the current inverted yield curve1 as a leading indicator of an upcoming recession. We’ll say more on our opinion on the inversion below, but first note that we do not see an imminent recession. Ten years into an economic recovery, the calendar seems to validate this same concern. However, despite being long in the tooth, we believe the economic expansion will continue. While slowing, recent economic data still shows good job growth, near-record low unemployment, and continuing wage growth, all of which are supportive of continued growth in consumer expenditures. Additionally, recent rate cuts ought to provide a tailwind for business investment as well as reignite mortgage refinancing and housing demand. There is no doubt that consumer and small business confidence have been dampened recently by the negative news flow, but these economic indicators are still positive.

“...we do not see an imminent recession.”

Impact of Tariffs on the U.S. Economy

An area of true concern, and one that might tip us into a recession, is the manufacturing sector of the economy. One centerpiece of the Trump administration’s policy initiatives has been the attempt to revive domestic manufacturing, with a focus on leveling the playing field with our trading partners. This is not new news, but, despite recent glimmers of optimism, in the absence of fruitful negotiations (particularly with China), the U.S. has increasingly turned to tariffs in an attempt to pressure other countries, who have responded with their own tariffs. Unfortunately, this approach is much like fighting cancer; the body (domestic economy) suffers during treatment in the furtherance of the end goal. While the end goal is still not in sight, tariffs are producing a negative impact on the U.S. economy—particularly manufacturing. In the most recent ISM Manufacturing survey, which measures manufacturing activity, new orders, export orders, and manufacturing employment all plunged. Similar and likely greater economic pain is being felt in China, but who will blink first is up for debate.


Regarding the presidential election, it is far too early for much meaningful discussion—for now, one can only speculate. We will have more to say on potential impacts from policy debates in future writings. At this point, we remind you that, regardless of the outcome, the political system’s checks and balances will result in any change likely being incremental. Additionally, the primary election cycle tends to be more polarizing than the general election. Regardless, this won’t help dampen market volatility.

Interest Rates

The most significant development in the last year has been the level and direction of interest rates. While the Fed may have eventually succumbed to global interest rate imbalances, the persistently negative news flow gave the Fed added impetus to change course and lower rates to help bolster the domestic economy.

It could have been argued, solely looking at the domestic economy, that rates were already sufficiently low. However, in this increasingly global financial market with free capital flows, it would have been difficult to go against the tide of globally lower rates. With negative interest rates in Japan, Sweden, Switzerland, and the Eurozone, coupled with global tensions, it is little surprise that capital is flowing to the U.S. Dollar and Treasuries. We may scoff at earning 1.75% on a 10-year U.S. Treasury, but that far exceeds -0.4% on a 10-year German bond or -0.2% on Japanese 10-year debt. So, instead of the yield curve portending a recession, we believe the shape of the yield curve is being impacted by capital flows, trade, and continued low inflation.

“...instead of the yield curve portending a recession, we believe the shape of the yield curve is being impacted by capital flows, trade, and continued low inflation.”


Given these significant crosscurrents, it is not surprising that the domestic markets have gyrated, while remaining resilient. Backed by the strong dollar and better U.S. economic growth, domestic stocks have outperformed their international counterparts even with their higher valuations. As we mentioned earlier, despite a growing economy and modest risk-aversion, fixed income securities have generally outperformed stocks over the last year.

Where to From Here?

We expect the post-crisis expansion to continue, albeit at a slower pace, buoyed by a re-accommodative Fed. We need, however, to keep a close eye on the manufacturing side of the economy. Current conditions favor stocks, particularly those with dividends. Additionally, if any of the current negative factors—from Brexit, to U.S./China trade negotiations, to Iran and Twitter chatter—resolve themselves even slightly positively, there is the potential for the markets to climb materially higher. We see little reason for short-term dollar weakness, which ought to be good for investments denominated in the U.S. On interest rates, inflation is not dead, but we think rates will remain lower for longer. As the field for a Democratic candidate thins, we will begin to learn more about how potential policies may impact individual sectors.

“We expect the post-crisis expansion to continue, albeit at a slower pace, buoyed by a re-accommodative Fed.”

Volatility is likely to remain, especially given the duration of the recovery and lingering national and global tensions. As we always remind you, make sure your portfolios are positioned to be able to take the requisite longer-term view with the equity (growth) portion of your portfolio. In other words, keep reserves/liquidity available for those inevitable rainy periods when the sun isn’t shining on stocks.

1. An inverted yield curve is a condition in which interest rates on short-term bonds are higher than interest rates on longer-term bonds. This unusual condition traditionally occurs when market participants expect the economy to slow or go into a recession. In a recession, the Federal Reserve would need to cut rates to stimulate the economy, so investors move early in anticipation of pushing down longer-term rates.

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The above information is for educational purposes and should not be considered a recommendation or investment advice. Investing in securities can result in loss of capital. Past performance is no guarantee of future performance.

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