Storm Clouds Building

“I’m not afraid of storms, for I’m learning how to sail my ship.”
― Louisa May Alcott

The Clouds

The theme to our 2019 outlook was “be prepared” and we continue to see some clouds forming on the horizon.

Aside from trade/tariff volleys (if only we could move aside from trade news), the latest concern has been the inversion of the 10-year/2-year Treasury yield curve. As you can see below—similar to the 10-year/3-month curve that first inverted in March—the 10-year/2-year inversion has preceded every recession since the 1960s. However, there were two periods—in 1966 and 1998—when the yield curve inverted, but a recession remained a fair distance away.

10s-2s curve inverts

Recessions are inevitable and occur at the end of every economic cycle, so the U.S. economy is sure to have one. The unknown factor is the amount of time until it arrives, as the lead time from inversion until recession is highly variable:

• The median span from an inversion in the 10y-3m curve and recessions historically was 12 months—with a range of five to 23 months.
• The median S&P 500 performance during those spans was 4.2%—with a range of -16.6% to +22.8%.
• The median span from an inversion in the 10y-2y curve and recessions historically was 17 months—with a range of 10 to 24 months.
• The median S&P 500 performance during those spans was 4.4%—with a range of -12.0% to +30.0%.
• Of course, past performance is no guarantee of future results, but importantly, the ranges show that there is little consistency historically in terms of recessions’ timing or stock market performance in the aftermath of inversions in the yield curve.

Various pundits have dismissed both yield curves’ inversions this time around, citing the unique circumstance around why the curve inverted this year. Being mindful of the daring use of the phrase “it’s different this time,” the reality is that every cycle is unique in nature. This time around, the phenomenon of $17 trillion of negative-yielding global debt (Wall Street Journal) is certainly novel—and has undoubtedly led to significant safe-haven/higher-yielding purchases of longer-term Treasury securities. As such, unlike most past episodes, the curve inverted this time because long yields fell below shorter-term yields vs. the Fed raising short-term rates above long-term yields. That said, an inverted yield curve, when persistent (and regardless of why/how it inverted), does crimp or eliminate the spread banks can earn by borrowing short and lending long—typically constraining credit availability, a common precursor to recessions.

Trade tensions continue to mount

The trade picture has shown few signs of improvement, as global manufacturing continues to weaken and myriad manufacturers continue to express uncertainty and are holding off on capital spending due to the trade dispute between China and the United States.

Manufacturing around the world is reflecting trade pains

Due to the latest tariff escalations; and limited incentive for either side to compromise at this stage, we see little prospect of a resolution in the near future. Barring some minor positive developments, the general rhetoric over the past couple of months has shown no evidence of a conciliatory tone. The tit for tat continues, and the longer the dispute and escalations continue, the more damage it is likely to do to corporate animal spirits and capital spending intentions. The prospective risk is that manufacturing’s weakness starts to bleed into the consumer/services side of the economy. This may already be underway, with the latest services purchasing managers index (PMI) from Markit falling to 50.9 (which is barely above the 50 mark denoting expansion). The slide coincided with a weaker manufacturing reading, which did dip to slightly below the 50 line. This weakness into services could be exacerbated by the fact that the next two rounds of tariffs on Chinese imports are a direct hit to consumer goods.

The sunny sky

For now, the U.S. consumer is chugging along. Retail sales in July surprised to the upside with a robust reading of 0.7% month-over-month while, excluding the more volatile autos and gas components, sales increased 0.9% month/month and 4.2% year/year. Consumer confidence remains solid due to wages trending higher and jobless claims sitting at historically-low levels.

Consumers bolstered by rising wages…

…and a strong labor market.

Mid-cycle adjustment, or something more?

For now, the Fed appears to be more focused on the consumer’s strength in holding up the economy. The July Federal Open Market Committee Meeting (FOMC) minutes reiterated what Fed Chairman Jerome Powell noted immediately following the FOMC meeting last month—that the July rate cut was a “mid-cycle adjustment” rather than a “pre-set course” for an easing cycle. Yet, despite that, investors are still pricing in at least two more cuts this year. The divergence between these expectations and the Fed’s signaling will have to be resolved at some point, and market volatility could increase along with convergence.

Good news on trade (for a change)

Though the back-and-forth between the United States and China has commanded nearly all the attention, President Trump and Japanese Prime Minister Abe worked to find common ground while at the Group of 7 (G-7) summit in France. In fact, President Trump stated that, “We’ve agreed to every point.” Japan is the third largest economy in the world, behind the United States and China; and agreed last week to a trade deal that would allow more agricultural exports from the United States, and avoid new tariffs on Japanese cars exported to the United States.

Lost in the escalating trade tensions with China is the fact that the United States now has trade deals signed or pending with Japan, South Korea, Canada and Mexico—making up four of the United States’ top seven trading partners—accounting for a combined 60% of U.S. trade.

U.S. top trading partners

*Total trade for 2018.
Source: Charles Schwab, U.S. Census Bureau data as of 8/28/2019.

As mentioned, tensions are still multiplying between the two largest economies in the world, painting a darker picture that doesn’t show signs of improving. As you can see in the chart below, global trade has stalled as a global economic slowdown and concerns over rising trade barriers have taken effect. This has spilled over to corporate earnings, with the outlook remaining cloudy for multinational companies that make up the major stock market indexes.

Global trade volume has stalled

Source: Charles Schwab, Bloomberg data as of 8/28/2019.

Nevertheless, the U.S.-Japan trade deal is good news and highlights a potential bright spot in the trade malaise. Since the latest round of tariffs between the United States and China was announced on August 1, Japanese stocks have outperformed U.S. stocks. The MSCI Japan Index slid -2.0% while the S&P 500 Index fell -3.7% from July 31 through August 27 (measured in U.S. dollars).

A trade deal may not be the only reason for Japan’s outperformance. Japan’s manufacturing sector is showing signs of stabilization, based on the country’s PMI, which bottomed in February. Other positive news included machine tool orders jumping 9% in July and a positive economic surprise index (Citigroup Economic Surprise Index, —indicating economic data has been exceeding economists’ expectations. Yet, Japan faces some headwinds, which include an increase in its value-added tax (VAT) in October from 8% to 10%; and a trade skirmish with South Korea, where the two countries have dropped each other as favored trading partners. Japanese stocks’ outperformance demonstrates the potential for some countries to provide shelter from the U.S.-China trade storm and highlights value of holding diversified portfolios.

So what?

While manufacturing continues to weaken and the U.S.-China trade dispute shows no sign of a resolution, the U.S. consumer continues to power the economy thanks to positive wage growth and a tight labor market. However, it’s prudent to be prepared for more bouts of volatility, and investors should make sure they are keeping a diversified portfolio with equity exposure equal to their risk tolerance. Within U.S. stocks, we continue to favor large cap stocks over small caps; while recommending a fairly defensive sector positioning, with emphasis on health care, utilities, and staples during market rebounds (for more detail see Drifting Toward Defensives). We don’t recommend trying to trade around short-term moves, but rather focusing on the long-term, remaining disciplined, and using bouts of volatility as opportunities to rebalance.