HFA Market Outlook – Spring 2019

Thomas BalisApril 5, 2019


Last month, a brief inversion of the yield curve brought pundits out in force to prognosticate upon the possibilities of a coming recession.  Concerns about Brexit, fears about the ongoing trade conflict with China, and the possibility of auto tariff escalation with Europe have created angst for many an investor.  Indeed, one might wonder how in the world the U.S. Stock Market (as measured by the S&P 500 Index, a broad measure of large public U.S. companies) recovered from the plunge in the fourth quarter to gain over 13% in the first quarter of 2019. Has the market come too far too fast?  Is there a recession on the horizon?  What are we doing with investment portfolios in response?  These are questions that deserve thoughtful attention.

What is a yield curve inversion, anyway? More important, why do some feel it predicts recessions?   Simply put, yield curve inversions happen when short-term interest rates (controlled by the Federal Reserve) become higher than long-term interest rates (more controlled by inflation expectations in financial markets).  Research has demonstrated that every recession in the past 50 years has been preceded by an inverted yield curve, so when it happens, the recession hawks come out of the woodwork.  However, not every yield curve inversion has resulted in a recession.

Importantly, the recent inversion was very brief, with the 10-year Treasury yield dipping very briefly below the 90-day yield.  Many economists believe an inversion only becomes predictive when it is sustained for at least one full quarter.  When that happens, any recession that does occur, generally does so in the following 6 to 24 months. Why?  Inversions have historically happened when central banks have raised short-term raises to combat inflation, and have generally over-corrected.  While the Fed has raised rates over the last 3 years to their current range of 2.25% to 2.50%, these are nominal rates, unadjusted for inflation.  When adjusted for core CPI (a common inflation metric), the real federal funds rate is currently 0.32%.  For comparison, the average real federal funds rate over the past five rate hiking cycles is 3.97%.  Thus, the economy is quite far from the Fed causing a recession by raising interest rates too far too fast.  In addition, the Fed’s recent announcements indicate no further rate hikes are expected in 2019.

So what about the trade conflict with China, and auto tariffs, and Brexit, and so on?  There is little doubt that the news flow around these topics can undoubtedly move stock markets.  While this may cause some market volatility, the impacts on the U.S. economy are likely somewhat more muted.  The reality is that the rest of the world is far more sensitive to trade than the U.S.  China’s exports are equivalent to 19% of its GDP.  The Eurozone’s exports are 20%.  U.S. exports are only equivalent to 8% of its GDP. So, while world trade volume has decreased in the past year, it frankly impacts the rest of the world far more than it does the U.S.

The U.S. Stock Market had a huge rally in the first quarter.   Has it come too far too fast?  Maybe not.  A common valuation metric, the forward price to earnings ratio (P/E) of the S&P 500 was at 16.4X at the end of the quarter.  The long term average (25 years) is 16.2X, thus markets are far from excessively overvalued.  If anything, with the Fed on pause on rates, multiples could actually expand this year.  Of course, investors will be watching closely for guidance on the rest of the year, which could be either good or bad for stocks.  Any market pullbacks will be opportunities to buy or rebalance portfolios.

So, is a recession coming, or not?  Well, all market expansions eventually end in a recession.  When that will actually happen depends on who you ask.  Jeffrey Kleintop, Chief Global Investment Strategist at Charles Schwab, has written about elevated risks of a global recession in the coming six to 18 months.  In contrast, J.P. Morgan’s Chief Global Strategist, Dr. David Kelly sees little possibility of recession in 2019 or 2020.  HFA’s base case tilts to the latter.  We continue to remain cautiously and modestly optimistic for the remainder of 2019, particularly in light of the Fed’s pause on interest rate hikes.  Nevertheless, broad risks do, in fact, remain.  A short-term pullback to consolidate recent market gains would hardly come as a surprise.  Any adverse outcomes in trade negotiations could certainly rattle markets.

With these manifold risks in mind, HFA continues to manage our portfolios defensively.  Rebalancing to sell down portfolio sleeves that have generated profits in order to buy into those sleeves that are ‘on sale’ continues to be core to what we do.  We also continue to maintain a specific allocation to U.S. Treasuries in our fixed income models.  While we generally avoid short term tactical moves, we are currently evaluating additional sub-asset classes for inclusion in our portfolios given the lateness of the economic cycle.  As a fiduciary, HFA is committed to timely communication of any proactive adjustments we make in light of changing market conditions.  As always, reach out to your HFA advisor if you would like to discuss your portfolio.



J.P. Morgan, Guide to the Markets, 2Q 2019
CNBC.com, The US bond yield curve has inverted. Here’s what it means, 3/25/2019