April 8 2019 Market Update

The Future is (Still) Uncertain

The S&P 500 rose 1.8% in March 2019 to deliver a first quarter return of over 13%, its strongest performance in a decade.^[1]This came on the heels of the S&P 500’s tough close to 2018, the index’s worst quarterly performance since 2011. If you were curious about whether volatility is back, we believe you have your answer.

March also brought a notable yield curve inversion: yields on 3-month Treasury notes briefly exceeded those on 10-year Treasury bonds for the first time since 2007. This is something we’ve touched on in the past and which has gotten a lot of attention by market observers. Based on this and a number of other data points, the market is increasingly betting on the Federal Reserve reversing course and cutting interest rates by the end of the year.

As we look ahead, there seems to be a general sense of optimism mixed with doubt – a kind of sentiment soup. But there are two significant issues on the horizon in the next quarter that we’ll be observing carefully: the political and economic experiment that is Brexit, and future gyrations of the yield curve.

Here’s what’s going on and what we think it means for your portfolio.

In Global News: Does Brexit Matter? 

Brexit negotiations have been going on so long you’d be forgiven for losing track – after all, emotions have been running high for the better part of three years. After a series of stinging defeats for the plan put forward by Prime Minister Theresa May’s cabinet, it is beginning to look like a “no deal” or “hard” Brexit is increasingly likely.^[2]

The United Kingdom originally had until April 12 to propose an exit deal to the European Union, which would have had to review and accept the terms. The concern over the past weeks has been that the UK would reach the deadline without any proposition in place, triggering an immediate, no-deal exit.^[3]

As of this writing, the deadline has been extended to October 31. This provides a degree of relief, but it also complicates matters somewhat – with a new session of the European Parliament starting on June 1, the UK will need to either participate or engineer an exit prior to that date.^[4]

In short, the situation is quite messy. What are the possible outcomes?

The UK has amassed reserves in preparation for potential shocks to the economy, but depending on the way negotiations evolve, an eventual exit could see anything from a depreciation in the British pound sterling to interruptions in trade with Europe. British companies have already started amassing inventory in case of delays due to border problems, and the UK has indicated it will adopt an open stance towards trade should no deal with the EU be reached. This could help reduce some of the immediate pressures of leaving.^[5]

At the same time, this situation is coming to a head in the context of economic weakness across Europe

European manufacturing activity fell in March at the fastest rate in six years, while inflation readings have also fallen. While some of this might be seasonal, there is concern that the additional uncertainties of Brexit, politics, and global trade could put even more pressure on the EU.^[6]

All that is to say that things across the pond are complicated right now. We expect additional pressure and possibly some volatility going forward as the impact of Brexit – whatever form it might take – and continued global trade negotiations unfold.

In Local News: Does the Yield Curve Matter? 

Another major event this March was the notable, if temporary, inversion of the Treasury bond yield curve. Yields on 10-year Treasury bonds fell below those on 3-month T-bills, meaning that an investor could earn more money from buying short term bonds than long term bonds – not a typical state of affairs

This is a closely-watched indicator because it historically precedes recessions. Does that mean one is imminent?

The first and most important issue is that the lag-time between a yield curve inversion and recession isn’t consistent. While there is a consistent historical correlation, it’s difficult to make the argument that everyone should start worrying right now. In fact, some analysts believe that this time the yield curve inversion is nota signal to be worried about at all, regardless of the history.^[7],[8]

Finally, a relevant point is how long the yield curve stays inverted. In March, the move was temporary. While it may invert again, there are arguments to be made that a momentary inversion matters less than a consistent one.

Obviously, there are a number of other factors involved, which means not every economist or market analyst agrees about how important this indicator is right now – or at what point it becomes a signal about the future.^[9] Given the concern, though, markets are betting on a 64% chance of a Fed rate cut by the end of the year – which could, of course, impact the meaningfulness of the inversion itself.^[10]

In our view, the reality is simple: eventually, every economic expansion comes to an end. A recession at some point in the future is inevitable – from the mid-1800s, we’ve experienced the cyclicality of the business cycle time and again.^[11]

But when a recession occurs, what precedes it is not nearly so clear-cut.

We treat the yield curve as an important data point among many other data points. It helps us to understand what’s happening in bond markets and what the potential impact of those events might be in the future. But it doesn’t provide us or anyone else with flawless insight into the future.

Instead, we take the long view and build an understanding of the business cycle into our strategies. Whether it’s a political issue or an economic one, the movements of the markets at any given time are unpredictable – but they do follow certain long-term patterns.

In short, we don’t believe in the “this time it’s different” philosophy of investing. The math and the history support the benefits of diversification and discipline, particularly in times where fear, greed, or any other sentiment take hold. We’ve built an understanding of long-term bond trends and short-term economic risks into our strategies, and we encourage you to reach out if we can answer any questions.

Holiday Celebrations and Closures

Southern California isn’t known for having distinctive seasons, but with the incredible superbloom of wildflowers this year after a wet winter it’s hard not to appreciate spring. We hope the natural beauty of the season finds its way to you this year, too.

For those who observe the spring holidays, we’d like to take the opportunity to wish you joy and quality time spent with loved ones. In observance of both the Passover and Good Friday holidays, we will be closing the office early at 12pm Pacific on Friday, April 19^th.

Thanks as always for your continued support.

JSF Financial