In a way the market has no memory day to day or week to week. And maybe it shouldn’t. But it is a sign of the uncertainty out there that the Dow can swing more than 700 points in the space of just a few hours on Thursday. Or how the S&P can be up +4.8% last week but down -4.6% this week. Trying to read some deep meaning into the daily or even weekly swings is nigh on impossible. The whipsaws this week, especially as they relate to trade, were particularly sharp.
By the end of the week global equities ended up broadly lower, giving back most of their gains from last week. Bond yields also closed materially lower and the yield curve flattened further. German bond yields pushed to new lows for the year if you can believe it.
Oh, and then there’s bitcoin. Oh my!!
More Evidence of Slower Growth
Let’s first get the major economic report of the week out of the way. Friday’s payrolls report came in a bit on the soft side. The headline jobs number was up 155K in November – about 35K below expectations. The previous two months were revised down by 12K, but the unemployment rate was unchanged at 3.7%. Not great but not bad.
The number everyone is focused on is wage growth. Accelerating wage growth would imply a more aggressive Fed. However, wage growth was a tad softer in November – so not too hot and not too cold.
In general, the theme of slowing global growth persists. For example, the Atlanta Fed’s estimate for 4th quarter growth fell to 2.4% this week, the lowest estimate so far, but nowhere near outright contraction.
What’s Driving Volatility? #1 = Trade
But why the volatility? After all, the stock and bond markets are not whipping around minute by minute because growth expectations tick lower by a tenth of a percent. What gives?
Well, first up is trade. Trying to follow the daily news will give you whiplash. Just take the news this week:
– On Monday investors breathed a short-lived sigh of relief following the G20 summit after President Trump agreed to postpone raising tariffs on $200bn of Chinese imports. For his part, President Xi Jinping pledged to engage in substantive talks to open up the Chinese economy to U.S. imports.
– The relief didn’t last long. By Tuesday the President called himself ‘tariff man’ and ominously warned that “We are going to have a REAL DEAL with China, or no deal at all – at which point we will be charging major tariffs against Chinese products being shipped into the United States.”
– Things calmed down a bit on Wednesday after Trump sounded more conciliatory and China said they would resume importing soybeans and liquefied natural gas from the U.S.
– But then things went off the rails again Thursday after a high ranking Chinese executive was arrested in Canada at the behest of the U.S. government on suspicion of violating sanctions against Iran.
Phew. That’s a lot for one week.
What’s Driving Volatility? #2 = The Yield Curve
Another factor behind the increase in volatility are growing recession worries. It isn’t the case that the economic data are pointing towards a contraction. It is more the case that a key financial market indicator is tipping in that direction.
We’ve talked about the yield curve in the past, and this week one component of the yield curve inverted. Specifically, the yield on the 5-year Treasury bond fell below the yield on the 2-year Treasury bond (see chart below) by 1bp or 0.01%. This is the first time this has happened since before the financial crisis.
An inverted curve has generally been a pretty good predictor of recession in the coming months. By way of background, our post on June 7th dug into the details of the yield curve. You can read more here. But analysts typically look at the spread between the 10-year Treasury and 2-year yields. This remains positive, although the spread has shrunk lately.
Is the yield curve flashing a warning sign? Well, maybe, but it takes a while for these things to play out. Even after the 10-year/2-year curve inverts, it has historically taken a number of months for a recession to begin, as you can see below.
Abut we are not there yet. We need to see the 10-year/2-year curve invert first. People are clearly trying to front run the early warning sign. They are anticipating the anticipator.
What’s Driving Volatility? #3 = The Fed – Will They or Won’t They?
Then of course we have all the speculation about Fed policy.
On the one side are the hawks – those who think the Fed will hike in December and follow it up with four more hikes in 2019. In this camp would go Goldman, J.P. Morgan, Bank Credit Analyst, and quite possibly a number of Fed board members. New York Fed President John Williams noted this week that the Fed should continue raising rates “over the next year or so” and said the U.S. economy was “on a very strong path with a lot of momentum.”
On the other side of the debate are a growing chorus of doves. Slower global growth, the lack of inflationary pressures, market volatility, and a flatter yield curve are all reasons given for the Fed to either not hike in December or hike but signal an end. For example, Jeff Gundlach at DoubeLine told Reuters this week:
“If the bond market trusts the Fed’s latest words about ‘data dependency’ then the totally flat Treasury note curve is predicting softer future growth (and) will stay the Fed’s hand.”
Similarly, Rick Reider at BlackRock noted the following:
“People keep waiting for the bogeyman coming in terms of inflation, and they’re going to have to wait a long time. Why not pause?”
Certainly, the bond market itself has gone a long way towards pricing in fewer rate hikes. The odds of a rate hike in December are still reasonably high at roughly 60%. However, the odds of further hikes next year have fallen dramatically (see chart below):
– The market is now pricing in nearly a 40% chance the central bank doesn’t touch interest rates again next year
– The odds of only one hike now stand at 33%
– The odds of 3 hikes are running at just 2%.
Adding to the uncertainly are articles like this in the Wall Street Journal. Is this just a journalist speculating about policy to fill space? Or is someone at the Fed trying to manage expectations through strategic leaks?
Of course, there are other reasons for the market volatility. Runners up include worries about Italian debt, the sharp drop in oil prices, corporate credit concerns, and the Brexit mess (and this is truly a mess). But these would be our top three. The tension is likely to build going into the fed meeting in twelve days.
Where There’s a Will There’s a Way
I must admit I’m a sucker for Churchill anecdotes and quotes. Some good ones include:
“History will be kind to me for I intend to write it.”
“No one pretends that democracy is perfect or all-wise. Indeed, it has been said that democracy is the worst form of Government except all those others that have been tried from time to time.”
“The water was not fit to drink. To make it palatable, we had to add whisky. By diligent effort, I learnt to like it.”
But I’d forgot about Churchill’s doctor note story until I came across it again this week. Churchill visited the U.S. in 1931 during prohibition to give a series of talks. For a well-seasoned (or is that pickled?) drinker like Churchill this presented a problem. In December of that year he managed to get himself run over in New York. After some R&R in the Bahamas he returned to the U.S. to complete his lecture tour. His doctor in the U.S. provided him a ‘get out of jail free card’ to dodge the prohibition enforcers. Perfect!!
“The quantity is naturally indefinite…” Naturally.
Have a good weekend.
Published by Gemmer Asset Management LLC The material presented (including all charts, graphs and statistics) is based on current public information that we consider reliable, but we do not represent it is accurate or complete, and it should not be relied on as such. The material is not an offer to sell or the solicitation of an offer to buy any security in any jurisdiction where such an offer or solicitation would be illegal. It does not constitute a personal recommendation or take into account the particular investment objective, financial situations, or needs of individual clients. Clients should consider whether any advice or recommendation in this material is suitable for their particular circumstances and, if appropriate, see professional advice, including tax advice. The price and value of investments referred to in this material and the income from them may fluctuate. Past performance is not a guide to future performance, future returns are not guaranteed, and a loss of original capital may occur. Fluctuations in exchange rates could have adverse effects on the value or prices of, or income derive from, certain investments. No part of this material may be (i) copied, photocopied or duplicated in any form by any means or (ii) redistributed without the prior written consent of Gemmer Asset Management LLC (GAM). Any mutual fund performance presented in this material are used to illustrate opportunities within a diversified portfolio and do not represent the only mutual funds used in actual client portfolios. Any allocation models or statistics in this material are subject to change. GAM may change the funds utilized and/or the percentage weightings due to various circumstances. Please contact GAM, your advisor or financial representative for current inflation on allocation, account minimums and fees. Any major market indexes that are presented are unmanaged indexes or index-based mutual funds commonly used to measure the performance of the US and global stock/bond markets. These indexes have not necessarily been selected to represent an appropriate benchmark for the investment or model portfolio performance, but rather is disclosed to allow for comparison to that of well known, widely recognized indexes. The volatility of all indexes may be materially different from that of client portfolios. This material is presented for informational purposes. We maintain a list of all recommendations made in our allocation models for at least the previous 12 months. If you would like a complete listing of previous and current recommendations, please contact our office.