Investment Insights: The upside down

Wade Balliet
Posted by Wade Balliet
Investment Strategy

This weekly report presents insights from our Global Investment Management team.

Financial markets faltered last week over global economic growth concerns and a corresponding move in Treasury rates that left investors feeling anxious.

The S&P 500 lost 1.89% on Friday before fluctuating over the past few days. Most of the recent volatility was likely driven by a large, unexpected miss in German manufacturing PMI, which added to a surprisingly dovish tone from the Fed earlier in the week, and left investors wondering if economic data would continue its negative trend.

Housing starts in the U.S. came in notably lower than expected in February, declining almost 10% versus a year ago, according to U.S. Census Bureau data. The latest risk-off sentiment and trends in economic data have had a significant effect on Treasury yields.

Today, the 10-year Treasury yield fell below 2.4% amid a move toward safe haven assets and growing worry over the economy. The recent decline in yield led to an important milestone for bond investors and economists alike: The 3-month Treasury bill is now yielding more than the 10-year Treasury for the first time since 2007. Inversion, as the phenomena is known, violates a fairly basic rule for investors: The longer the time horizon, the more you should be paid.

While a smaller part of the yield curve had already flipped this year, the inverting of the 10-year yield versus select shorter maturities has been a historical indicator of an impending recession. Our team doesn’t think this spells gloom and doom for the markets and the economy just yet. It’s important to note that only part of the yield curve is inverted. Usually an inversion of the shortest to the longest part of the curve is the most reliable indicator of a recession, and spreads within the bond market haven’t raised any red flags yet. Based on these changes in rates, the current environment seems to be one of positive, though lower, returns for the time being.

Lower expectations for stocks are also being baked into the markets. We have previously touched on the extraordinary earnings growth U.S. companies experienced in 2018, mostly driven by tax cuts and supportive economics. With those effects fading, it will be difficult for corporations to increase profits from the levels we saw last year. As such, the Wall Street consensus expectation for earnings growth during the Q1 2019 season is currently -3.7%, according to FactSet. Further, of the 105 S&P 500 companies that have issued guidance, roughly three times as many companies are expecting negative earnings growth compared to positive growth. Again, we don’t think this means we’re headed into a bear market, but there will likely be headwinds facing further gains in stock prices.

We see the recent dovish Fed comments priced in to the stock market, particularly due to the market placing a higher probability on the Fed making an interest rate cut this year rather than a hike. The possible positives for the market include a potential resolution of the U.S.-China trade dispute, and another round of crucial votes by British Parliament to keep Brexit on track for the new April 12 deadline mandated by the EU Council. Our strategies continue to hold a slight overweight to stocks, which has been beneficial, but the question now is what’s next.

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Investing involves risk, including the possible loss of principal and fluctuation in value. Economic and market forecasts reflect subjective judgments and assumptions, and unexpected events may occur. Therefore, there can be no assurance that developments will transpire as forecasted. The information in this newsletter is for informational purposes only and is not intended to be investment advice or a recommendation. Nothing in this newsletter should be interpreted to state or imply that past results are an indication of future performance.

Fixed income securities are subject to interest rate, inflation, credit and default risk. The bond market is volatile. As interest rates rise, bond prices usually fall, and vice versa. The return of principal is not guaranteed, and prices may decline if an issuer fails to make timely payments or its credit strength weakens.

International securities involve additional risks such as currency fluctuations, differing financial accounting standards, and possible political and economic instability. These risks are greater in emerging markets.

Diversification and asset allocation do not ensure a profit or guarantee against loss.

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