Since we last wrote to you, a lot has been going on. If you can give us a few minutes, we’ll do our best to fill you in. In spite of seemingly endless concerns—which we will briefly review momentarily—markets have been generally strong, although there have been some uncomfortable stretches.
The short story: the market’s rally continued since the end of April, though its pace slowed considerably and it had a number of up-and-down swings. The S&P 500 is now up over 23% year-to-date through the end of October, making up for the painful correction in late 2018. Most of this year’s gain came in the first several months, but the S&P did pick up slightly better than 4% since the end of April. The Dow Jones was about one percentage point behind the S&P for the period, while the small-cap Russell 2000 actually fell back about a percentage point since our last letter. Large-cap international stocks benefited, gaining about 4% since our last letter to be up nearly 19% on the year.
Perhaps more eye-catching was the movement in bonds. The 10-year US Treasury, which was paying 2.50% in April, dropped all the way to 1.69% by the end of October, and was even lower briefly in August. That translates to a 6% price gain in bonds in a matter of months, a fairly remarkable occurrence. (We’ll get to the dreaded inverted yield curve in a few moments.) The Federal Reserve has cut rates not once, not twice, but three times (in July, September, and October) since we last met, trying to provide insurance against a possible recession, and perhaps acting, however reluctantly, in response to President Trump’s criticism of its relatively high rates. As we write its target range is 1.50% to 1.75%.
We note that inflation did pick up recently, exceeding the rate available on short-dated Treasury bills. It’s a bit unusual to see that in conjunction with a bond rally—just one of the strange events that has taken place over the late spring, summer, and early fall.
Across the country in New England, they say that if you don’t like the weather, just wait an hour. In the markets of late, if you don’t like the action, just wait a month…or a week…or a day. As we so often see, this argues for a patient, long-term plan.
Let’s start with probably the biggest overall market influencer, the ongoing trade war with China. In July, it seemed that a deal was near, and markets acted accordingly, making new highs. But in early August, President Trump announced new tariffs, and on the morning of August 23rd, he went a step further, increasing tariffs and ordering “great American companies to look for alternatives to China.” Gold, notably, rose by 2% that day, while major equity markets went about that much in the other direction.
It didn’t take long for the Chinese news to turn, at least somewhat. On August 30th, China said it wouldn’t retaliate (at least not initially) for the increased tariffs. By mid-October, there was talk of a first-stage settlement of the trade war, and while many analysts were skeptical, the market reacted favorably.
The US trade war is not the only Chinese concern. The ongoing protests and riots (you choose the term) in Hong Kong have already started a recession there, with potential for broader implications. And, keeping focused on Asia for the moment, India’s economy and markets have struggled enough over the past three years. The government in late September announced a major tax cut, at least momentarily turning markets higher.
It’s clear that investors are paying up for “safety” in Europe, while companies don’t seem eager to borrow for new projects. Negative rates make traditional saving far more difficult, and they have the perverse effect of allowing “zombie” companies that probably should shut down to keep going. Not surprisingly, the Euro hit its lowest level versus the dollar—less than 1.10—since May 2017.
A trip across the English Channel takes us to the Brexit saga. Skeptics have long wondered whether the UK will ever really leave, but it’s almost the literal definition of uncharted territory.
Enough about the overseas concerns. What about here in the States? We got a big scare in August when the yield curve inverted, with 10-year Treasuries paying less than 2-year ones. While it may sound odd that borrowing money for a much longer time is cheaper than in the near term (and it is), it’s certainly not as odd as negative rates, which we thankfully don’t have. But after a favorable purchasing manager’s report in late August and an October “Goldilocks” employment number, not too hot, not too cool, the curve recovered its normal shape in September.
Still, why were we hearing so much about the inverted yield curve? Here’s a very brief lesson. Historically, inverted yield curves (the name comes from the downhill slope on an interest-rate graph, with rates on the y-axis and time on the x-axis) have been reliable predictors of a recession, though the timing has varied considerably.
More importantly, remember that good financial practice involves matching assets and liabilities. That means you should pay for long-term projects with long-term financing (just as most people take long-dated mortgages when they buy houses). When 10-year rates are lower than 2-year rates, it suggests companies are eager to neither borrow or build.
Finally, put yourself in the position of a bank. Banks borrow short-term money and lend it long-term. If it generally costs them more to borrow than they can make from lending, they’re likely to cut back on their activity, thus slowing the wheels on which the economy turns. So inverted curves are uncommon, and they can be a bit scary.
What did we leave out? All kinds of US political activity, including an impeachment inquiry, the abandonment of a former ally in Syria, and frightening diplomacy with Iran. Oil briefly spiked 12% when a drone, reportedly launched or at least permitted by Iran, took out half of Saudi Arabia’s oil production capacity, though it fell back in a matter of days. Over the period since April’s close, oil took it on the chin, falling nearly 18% to just over $54. Gold had a big run since April, gaining over 15% to $1,512.
The bottom line: as we said initially, the ups and downs of recent months are yet more evidence of the importance of sticking with a long-term plan, subject to periodic rebalancing. Even—perhaps especially—some of the most volatile periods generally reward investors who maintain such plans.
Questions? Call your Regency advisor at (559) 438-2640.