As equity markets began to hit all-time highs in July, a variety of economic and market developments arose to boost volatility. Persistent concerns about trade, Fed policy, and long-term rates have made it challenging for equity markets to establish stability. Still, despite heightened volatility, losses have been relatively small, and valuations, while elevated, still look reasonable. Further, the ever-changing and unpredictable macroeconomic environment only further supports holding well-diversified portfolios for the long-term.
Interest Rates and Yield Curves
U.S. long-term interest rates have continued their downward trend since peaking in late 2018. As equity market selling pressure intensified in mid-to-late August, the 10-year US Treasury yield fell as low as 1.47% with investors demanding safe-haven assets. The 10-year rate declined about 40 bps in August alone. Uncertainty about the number of expected cuts by the Federal Reserve as well as the Federal Funds rate also pushed down longer-term rates.
The shape of the yield curve is another story gaining attention. Usually, the yield curve is upward-sloping, with long-term interest rates exceeding short-term rates as investors require additional compensation for taking on the additional risk of lending for longer periods. A yield curve “inversion” represents the opposite of this normal scenario, in which shorter-term rates are higher than longer-term rates. Experts have observed that the US yield curve has inverted before each recession of the last 50 years, with one false positive.
There are some caveats that can stem any immediate rush to judgment, however. For example, the observation can be difficult to act upon. The time frame between past inversions and the subsequent recessions has ranged from a couple of quarters to over two years, and strong equity returns have been observed at the end of past economic cycles. Additionally, it is hard to establish an intuitive economic relationship between the shape of the yield curve and growth.
General Economic Overview
One partial explanation for economic weakness could come from the financial sector. Banks and other financial institutions derive a good portion of their income from lending at longer-term rates and borrowing at shorter-term rates. When the spread begins to narrow and possibly turns negative, profitability can take a hit. This has been reflected in weakness in bank stock performance that strongly correlates with moves toward a flatter yield curve. While it is difficult to hold a single sector responsible for weakness in the overall economy, the financial sector is a critical economic driver, and therefore, can increase the likelihood of broader weakness.
Prolonged trade disputes are another major factor driving price movements and economic activity. In early August, the United States announced tariffs of 10% on $300B of additional imports from China. This brought the total dollar value of US imports from China subject to tariffs to $550B, close to the total value of imports from China in all of 2018. China responded in kind by allowing the renminbi to weaken in what appeared to be an effort to boost Chinese exports. Later in August, China also announced additional tariffs on $75B of American goods, beginning on Sept 1 and hitting again on Dec 15, prompting threats of further increases in tariffs from the U.S.
Volatility and Valuation
Given the intensification of trade pressures and the uncertain path of future interest rates, equity volatility has risen since the end of July. Despite the recent increased number of daily losses of greater than 1%, at the time of this writing, the S&P 500 sits only about 3% below its all-time high. Even at the height of selling pressure at the beginning of August, the index had lost only about 7.5% of its value.
Interestingly, valuation multiples of U.S. equities do not look excessive. The price to earnings multiple of the S&P 500 is roughly 22 times trailing 12-month earnings, which is higher than the long-term average of 15-16 times trailing earnings but less than highs exceeding 24 times trailing earnings in 2017 and 2018. Dividend yields tell a similar story: The S&P is yielding roughly 1.9%, higher than the interest rate on most maturities of US government debt.
No doubt, a great deal of uncertainty exists. However, uncertainty always remains as a constant. Federal Reserve Chairman Jerome Powell’s comments last Friday also acknowledged future economic uncertainty and risks, particularly around trade policy, and at the same time, reiterated a favorable outlook for the U.S. economy, highlighting moderate growth, a strong labor market, and inflation moving closer to the Fed’s 2% goal.
While we cannot accurately predict when uncertainty will negatively impact the markets (risk-off) and when it will be an afterthought (risk-on), we continue to strive to build and manage durable, all-weather portfolios that aim to return the highest level of return for each unit of risk taken. Having an asset allocation with which you are comfortable, regardless of market environment, is paramount to staying invested for the long-term. And, conceding that timing the market is an endeavor not worth the effort, staying invested over the long-term is one of the most powerful tools an investor has to achieve robust, compound returns.