An uptick in volatility emerged this week, as investors sought safety in light of last week’s Fed decision and a slew of negative data on the economic front. From the Fed’s pause in rate hikes to housing data to consumer confidence and trade, a mostly gloomy outlook has clouded the current expansion’s future. Adding to the pain, GDP reports for 4th quarter of 2018 were revised down significantly, with the tax cuts providing only marginal gains for the US economy in 2018. Outside the US, Brexit remains in the spotlight, as the deadline for a decision nears and some progress is being made in negotiations. Theresa May announced that she would resign if it would move forward a decision with the European Union, and votes will be held in the coming days to determine the next moves for the beleaguered nation. A third vote for the Brexit divorce will be held Friday to determine if May’s deal has a chance. Meanwhile on the trade front, US negotiators are in Beijing this week, hoping to break the deadlock that has seen both sides move back from the table. Initial reports of progress have been met with skepticism, but hope remains high that the two sides can determine an amicable outcome that could turnaround global trade growth and spur a reversal of recent economic weaknesses on both sides of the Pacific.
Perhaps the biggest concern many investors have raised is the recent inversion of key rates in the yield curve, specifically 3 month Treasury bills and 10 year Treasury notes. This phenomenon occurs when investors believe the Fed will reduce short term rates, and investors pile into longer dated bonds for outsized gains in bond prices ahead. An inverted yield curve has been a reliable predictor of recessions, having occurred prior to each of the last seven economic contractions. However, there are several caveats that put this instance into broader context. One, monetary policy post-2008 has seen unprecedented actions both in the US and abroad with negative interest rates and quantitative easing that leaves the current unwind in uncertain territory. Second, employment data remains incredibly strong, and recessions have rarely, if ever, occurred while jobs were being added to the economy. Third, the global nature of the last recession has left rates worldwide subdued while international flows have increased, meaning the US yield curve is now heavily influenced by foreign buyers and sellers of US debt. Lastly, yield curve inversions have historically been seen anywhere between six and eighteen months prior to the start of a recession, with some of the most significant gains seen during the final quarters of a bull market.
For now, we have raised significant amounts of cash and rebalanced the portfolios to a more defensive posturing in light of the rally in equities this year. Bonds continue to be attractively priced despite the strong moves in yields this year, though we believe a pullback in rates is likely in the near term. Investors may have gotten ahead of themselves slightly by potentially overexaggerating the degree of the slowdown ahead. As has been seen time and time again during the 10 year bull market, the Fed has been in charge of this market, and their easing of policy will likely be sufficient to once again support risk assets. That being said, a balanced approach seems most appropriate at this time, as uncertainty has increased and the anticipated earnings reports unveiled over the next several weeks should provide more direction for stocks. As always, we continue to remain extremely focused on monitoring unfolding market dynamics and reacting only when appropriate.