Of Trade Wars and Yield Curves

3Q 2019

2019’s third quarter was another wild one in terms of volatility in the markets. July gave us a promising start as US stock markets set new all-time highs early in the month. August was less favorable to the US investor. It started with escalated trade war rhetoric between President Trump and China, and then the Treasury Department officially labeled China a “currency manipulator.” A week later, the yield curve officially inverted – a phenomenon where the interest rate on a ten-year Treasury bond drifts below the interest rate on a two-year Treasury bond – which many market pundits consider a harbinger of bad news to come. Thankfully, a calm September allowed the market to largely recover from the damage inflicted in August. That is until the House of Representatives announced a formal impeachment inquiry into President Trump. What a quarter!

Naturally, when headlines create volatility, investors often wonder, “Is this one ‘the big one’”? It’s notoriously difficult to know for sure. There is no question that global growth is slowing. Why? There’s no single answer as every region is facing unique challenges; Europe is mired in a slowdown that is largely a function of the European Union construct; Greece needs money and leadership, Italy needs leadership, France needs structural reforms, the UK needs a solid Brexit plan, and Germany needs to stop subsidizing everyone else in Europe. Emerging markets display pockets of growth, but the overall global slowdown is putting pressure on many of the emerging market countries that trade with China. But all of that can change on a dime. We’d expect trade to thaw and countries around the globe to benefit if the US and China can resolve their trade disputes.

The lone bright spot on the global stage is that US data is still positive. We continue to experience low inflation. Job growth is still positive. Yes, manufacturing is slowing, but that represents only about 14% of the US economy and service numbers continue to indicate economic expansion. Consumer spending represents about 70% of US GDP, and the US consumer is doing very well right now. Yes, government debt continues to drift higher, and while this is concerning, it’s important to keep in mind that debt is most relevant in a relative context. To that end, global government debt continues to move higher as well, as it has since the beginning of time. Demographic factors can support increased debt loads, and if economies continue to grow, population growth and (more importantly) productivity can allow economies to “grow into” their debt.

We say all of this not to be Pollyannish. The reality is that the US is likely to experience another recession at some point. Business cycles happen – we go through expansions and contractions that repeat like an irregular heartbeat. Now, the probability that a recession occurs in the next six months, 12 months, 18 months, or two years is completely unknown. Studies show that acting on some of the most “reliable” timing signals (like an inverted yield curve) can cause investors to miss out on several additional percentage points of return, as this signal is often a year or two in advance of a recession. Additionally, there are several arguments that the inverted yield curve signal may be wrong and should not be trusted this time because there are other factors influencing the US yield curve (e.g. central banks buying debt, negative foreign rates all over the world, aging US population). Maybe the most notable argument against trusting the inverted yield curve is this: if the Federal Reserve drops rates by 50 basis points, voila, the curve could just “un-invert” (revert).

Since the Global Financial Crisis, the reward for investing in global stocks has been 13.4% annualized (i.e. compounded annually) and that’s even after the 17% drop in late 2018! We advise investors to stay the course, avoid trying to time the market and take advantage of the inevitable market pullbacks. Like all the other stories that have made their way to the headlines over the past decade, this too shall fade.