Monthly Markets Memo - August 2019
by Dan Zalipski, CFA
The sleepy days of summer have been anything but. Last month the Fed cut interest rates by 0.25% in what they’re calling a ‘mid-cycle adjustment’. In other words, the Fed is saying this is not the start of a prolonged easing cycle with multiple rate cuts. The broader market seems to disagree as the futures market is pricing in one to three additional 0.25% cuts by the end of the year. Ultimately, the Fed is attempting to extend the current bull market and protect the economy from slowing to the point of recession. It is believed that rate cuts at this point in the cycle will do little to stimulate the economy as trade tensions and recession fears overpower the marginal benefits of lower rates.
With the cover of a rate cut, Trump re-ignited the trade war with China when he announced a new round of tariffs on the remaining $300 billion worth of Chinese imports that were not already subject to tariffs. China responded by halting all U.S. agricultural imports, and devalued their currency trying to offset the tariff’s effects. The market reacted negatively to both developments. China may be trying to delay a potential deal until after the election, where they may find themselves negotiating with Democrats should Trump lose. With the trade war damaging both China and the U.S. economy, the game has become one of endurance. Both will attempt to withstand the economic pain until one side yields.
The issues surrounding the Fed and trade have been a source of volatility within the markets. Investors are fearful, and nowhere is it more evident than the bond market. As investors pile into bonds, their prices go up while their yields go down. The yield on the 10-year U.S. Treasury has fallen from 2.02% at the end of July to 1.53% mid-way through August. In the world of Treasuries, this is a large move in both magnitude and pace. The buying spree reflects investors’ desire for safety as fears of a global slowdown or recession grow. The activity has caused the yield curve to invert with yields on the 10-year Treasury lower than yields on the 2-year Treasury. In the past, an inverted yield curve was considered an accurate predictor of an impending recession within the next 12-18 months.
The bond market may be getting ahead of itself. GDP growth is expected to slow but remain positive (a recession is two consecutive quarters of negative GDP growth). The consumer remains in a fundamentally strong position with a lower debt load compared to pre-crisis levels. Unemployment is at 50-year low, inflation is muted, interest rates are low, and consumer sentiment remains high. Retail sales just saw their biggest increase in four months. The economy, by traditional measures, is relatively strong. Other classic indicators of a recession, such as the Fed aggressively raising rates, excessive valuations within the stock market, or spikes in commodity prices are also absent.
Still, in the end, it may not matter. Whether right or wrong, the bond market is leading the way, and will likely weigh on stocks. Businesses will continue to grapple with the trade issues disrupting their supply chains and delaying capital investments. Consumers will continue to enjoy low borrowing costs, low unemployment, and low inflation. The silver lining in all of this is that the primary source of this volatility, the ongoing trade war, is man-made and therefore can be reversed. In a market that can swing wildly with a single tweet, we find it prudent to anchor our exposure to the longer-term fundamental aspects of the economy, and not get caught reacting to the shorter-term emotional swings.
"This market is now largely ruled by fear… …You don't panic when the economy is hanging on.” - Jim Cramer
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