FAQs on the Markets and Economy
Should investors be concerned about recent inversion of part of the yield curve?
Market alarms were recently raised when for the first time in over a decade, yields on five-year Treasury notes fell below two- and three-year Treasury yields. However, this is more of a kink than an inversion of the curve. Historically, this narrow segment of the curve has inverted many times without an ensuing recession.
A more reliable yield curve measure is the difference between 3-month rates and 10-year rates, as these are more representative of Fed rate moves and long-term growth expectations. This measure has flattened, but it has not inverted. Even an inversion of the broader yield curve (if and when this occurs) is not a signal of impending near-term trouble.
Historically, when this yield curve inverted, it was an average of 16 months before a recession emerged. Moreover, the 3-month/10-year rate spread is currently 0.47%. When the measure first breached 0.50%, the average return in the stock market over the next year was 12% in the three instances that this occurred since 1991.
We wouldn’t be dismissive of a flatter yield curve altogether — it is an important input to our forecasts — and if the curve were to actually invert, we would be more concerned. Still, the outlook for the economy, profits, inflation, and interest rates are more important for determining the direction of the stock market.
Has the Fed turned dovish on monetary policy?
Based upon recent statements from Fed policy makers, the market has become more dovish on their outlook for future Fed actions.
Back in early October, Chair Powell stated that the federal funds rate was a long way from the neutral level. The market was surprised by that comment and turned more hawkish. Since then, Powell and other policy makers have made statements stating that the funds rate is close to the neutral rate and the market has turned more dovish.
This has increased the uncertainty of the number of interest rate hikes that are expected in 2019. Based upon the most recent data from September, the Fed projects three hikes of 25 bps each slated for 2019. The federal funds futures market does not believe the Fed will be that aggressive. They now believe the Fed will hike about once in 2019.
This week the FOMC will meet and release their updated view of the economy, inflation, and the future direction of the federal funds rate. From that data, we will see if the Fed has turned more dovish.
Will the stock market recover or is this the end of the bull market?
We continue to view the current pullback as a correction, rather than a beginning of a more severe and prolonged downturn. In many ways, this market environment is similar to 2015/2016, when a slowdown in global growth, concern of the start of Fed tightening, and a collapse in oil prices put pressure on equities.
While the U.S. and global economic activity is expected to moderate in 2019, growth is still projected to be above potential and recession risk remains low. Likewise, we agree that earnings growth will slow next year, but to a more normal rate of about 5%. Trade tensions are headwinds, but we believe their effects on corporate profits should be manageable. The biggest risk to our outlook is interest rate backdrop. However, rates continue to be low by historical standards, and the Fed comments recently have provided some reassurance that central bankers are focused on the risk of overtightening policy and ending the cycle prematurely.
In the meantime, our client portfolios are constructed with this volatility in mind and should withstand the correction relatively well due to our high-quality equity allocation and overweight to U.S. Large Cap stocks versus MidSmall Cap and International.
What is happening with interest rates?
There is a convergence of interest rates over various maturities, which is normal at this stage of the business cycle (chart). Since the Fed began tightening monetary policy back in December 2015, short-term interest rates have been moving up at a faster clip than longer-term interest rates. Short-term interest rates have been moving in lockstep with Fed policy moves while longer-term interest rates have remained relatively stable.
Throughout this expansion and the two previous ones, longer-term interest rates have been moving downward. There are a number of reasons for this: lower inflationary pressures, lower expected inflation, savings glut (population getting older and becoming more risk-adverse with investments), and central banks buying up bonds as part of their unorthodox monetary policy of quantitative easing.
As for our outlook, we expect the Fed to continue with their gradualistic approach to normalizing interest rates. We expect three more increases (75 bps), with one move this December 19 and two moves in 2019. Longer-term interest rates we expect to remain in the current range due to a continuation of the fundamental factors mentioned above.
Is City National Rochdale’s investment outlook still positive?
Based on our outlook for solid economic growth and improving corporate earnings, we remain bullish on equities in general and continue to see attractive prospects in the opportunistic fixed income class. Bear markets outside recessions are rare.
Still, we believe investors should prepare for more moderate returns in the months ahead and perhaps greater volatility. Patience and discipline will be more important than ever. The investment landscape is growing more challenging as investors adjust to more typical late-stage expansion conditions of higher inflation, rising interest rates, and less accommodative monetary policy.
Meanwhile, concerns over global growth, rising trade tensions, midterm elections, and other geopolitical risks mean markets will likely continue to be subject to periodic swings in sentiment and potential pullbacks.
None of this means there are not more worthwhile gains ahead for investors, but it does highlight the value of active management and the need for investors to become more selective. We actively manage portfolios to be aware of where we are in the cycle, to take advantage of opportunities as they arise, and to be on alert if conditions deteriorate.