In the age of tweets and trade wars, it’s nearly impossible to get a great read on the markets. It reminds me of my summer trips to King’s Dominion as a kid, getting my head banged around on the old-school roller coasters. You always end up at the same place you began the ride, but the journey getting there was violent, thrilling and at times complex. I use the word complex because foreign relations and global trade is a very fluid variable with many moving parts. Markets seemed to be pricing in a positive resolution to the US-CN dispute a couple weeks back. The S&P 500 hit all-time highs, corporate earnings were respectable and the US consumer was carrying the economy along. How long ago does that feel now? The President’s tweet announcing an additional 10% tariff on the remaining $300 billion of goods imported from China set off the next phase of posturing that included the US labeling China as a “currency manipulator”.
As I write this, the S&P 500 is only a few percentage points away from its highs, bouncing off of the lows recorded on August 5th (2822) to the upper range around 2940. Bulls would certainly like to see those lows hold going forward to confirm a resumption of higher trends. However, there is considerable uncertainty with how the trade dispute impacts global growth and how businesses cut back on capital expenditures and eventually hiring new workers. This tit-for-tat seems to be less hopeful than other instances, as China retaliated by letting its currency weaken to offset the impact of higher taxes. They also asked state-owned companies to suspend imports of US agricultural goods. China also does not have the same urgency that Trump and his administration may have as they can choose to wait out the next US election to see if the Democratic ticket wins.
The Fed will likely need to step in to offset downward revisions to growth estimates. They recently lowered the lending rate by 0.25% for the first time in more than a decade and the market is pricing in much lower rates ahead. In the age of negative global interest rates, the US has some more levers to pull to stimulate economic growth. As depicted below, the odd shape of the yield curve is considered to be worrisome in many investment circles. Yield curve inversions are forward indicators for recessions. An upward sloping curve (1 year ago) usually signals higher expected rates of growth ahead. In the current environment, the bond market is pricing in slower rates of growth and a lower neutral rate of interest. By lowering the Fed Funds rate down to 1.50% that would require 3 additional rounds of rate cuts.
With the 3 month-10 year Treasury spread in negative territory, recession odds have been increasing. The New York Fed publishes a probability for US recessions in the next twelve months using this parameter. Currently, the odds for recession by July 2020 are around 30% and haven’t been this high since 2007.
So where does that leave us? With the acknowledgement that risks are clearly rising, this isn’t necessarily a definitive signal to push the eject button. The economy still is producing modest growth with low inflation. The Fed, for their part, is also becoming more dovish (unlike October 2018) which can offset the deflationary impact of the global trade war. We would use weakness to establish positions in companies that are well positioned in secularly growing industries and high quality stocks with strong balance sheets. Also, use market strength to properly align your risk tolerance. Now may be an appropriate time to begin trimming exposure to stocks if exposure is too high. Remember, cash is king in periods of market stress so don’t forget about its tactical purpose in times of uncertainty.
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