A Review & Game Plan for Today’s Wall of Worry


John Micklitsch, CFA CAIA, President & Chief Investment Officer
Kevin Gale, Managing Director, Head of Fixed Income

The trade conflict between the U.S. and China recently entered a new and potentially escalating phase. The volley of tariffs back and forth could lead to higher prices for consumers, greater uncertainty for corporations and the potential for a slowdown in the global economy. Since the announcement of the latest round of tariffs, economists have reduced U.S. 3Q19 and 4Q19 GDP estimates down to 1.9% and 1.8% respectively, which is below the previous 2.0%+ trend. For its part, China is experiencing an equal or greater amount of pain as a result of the tariffs and stands to lose 1.0% of growth from a sustained trade conflict.

Estimates for the global economy point to a 0.6% hit to growth from a sustained trade war, which could bring downside to the World Bank’s estimate of global GDP growth of 2.6% for 2019 and 2.8% by 2021. It is important to note, however, that potential deceleration is different than recession (defined as two consecutive quarters of negative year-over-year GDP growth) and that relief could come suddenly from any sort of breakthrough in negotiations. We believe such a breakthrough becomes more likely the closer we get to the 2020 presidential election. In the meantime, trade uncertainty will likely become the new normal for the markets.

Sensing some deceleration in the economy, the Federal Reserve (the FED) reduced interest rates by 25 basis points (bps) on July 31, which was the first rate cut since 2008. Furthermore, the FED appears ready to do more if necessary. In fact, almost all central banks across the globe are now easing, which puts further pressure on the FED to “keep up”. Bond investors are now pricing in a 100% probability of a 25 bp rate cut and a 30% probability of a 50 bp rate cut at the September 18th Federal Open Market Committee (FOMC) meeting.

For perspective on where benchmark interest rates are, on the day of the rate cut in July, the yield on the 10-year Treasury note closed at 2.01%. On August 1st, the unexpected tariff announcement lead to a significant flight to quality, pushing the 10-year Treasury note yield down to 1.89%. The flight to quality, in addition to an influx of foreign capital fleeing negative yields, has continued since, pushing the yield on the 10-yr Treasury note down to as low as 1.43% on September 3rd, its lowest yield since July of 2016.

U.S. Treasury 10-Year Treasury Note Yield

U.S. 10-Year Treasury Note Yield
Source: Bloomberg as of August 31, 2019

Of developed nations around the globe, U.S. bond yields remain attractive despite the significantly lower yields. The yield on the 10-year German note is -0.71%, the Japanese 10-year note is yielding -0.29% and the French 10-year note is yielding -0.40%. Over $15 trillion of global debt (approximately 33% of all outstanding global debt) now trades with a negative real yield. When adjusted for inflation, over half of all outstanding global debt now trades with a negative yield. This makes U.S. bonds attractive by comparison, which draws in foreign capital, pushing bond prices higher and sending our rates lower. Therefore, the capital flight into U.S. bonds could lead to a false signal in terms of what the recent drop in interest rates is telling us about the domestic economy. However, the decrease in rates cannot totally be dismissed.

On the positive side, despite the flight to quality and the increased volatility in equities, the corporate bond market has acted in an orderly fashion. Investment grade corporate credit spreads have widened by 19 bps since the July 31st FOMC meeting to 136 bps. For perspective, in 2019, Investment Grade credit spreads have traded in a range of 117 bps to 177 bps. High yield spreads have behaved similarly, widening 23 bps during the same time period to 394 bps. High yield spreads have traded in a range of 303 bps to 537 bps in 2019. Bottom line, while rates have fallen in an absolute sense, credit spreads are not blowing out disproportionately, which is encouraging in terms of foreshadowing the overall health of the economy and continued liquidity in the bond markets.

In terms of equities, the recent moves in the stock market appear to be a reaction to geo-politics and the uncertainty that trade, growing populism and low interest rates are creating in terms of future global economic conditions. As both the U.S. and China dig in, the likelihood of the “trade cold war” becoming the new normal increases, until either political or economic pressure caves to one side’s demands. The good news for long-term focused shareholders is that well managed companies, as they have in the past, will adjust supply chains to the new paradigm, creating fresh opportunities from the disruption. This would allow investor sentiment to stabilize and the market to build on itself once again.

In the meantime, the American consumer, who drives roughly two thirds of the domestic economy, remains resilient as evidenced by strong retail sales, low unemployment, strong household debt service ratios and personal consumption expenditure readings. Furthermore, lower valuations in and of themselves often lead to the “green shoots” of any market recovery. While sentiment can shift with a single tweet, long-term business values typically do not and, eventually, the market figures that out. Lastly, liquidity remains high as evidenced by strong money supply levels, meaning there is a lot of money still on the sidelines ready to buy the dips in this unloved bull market. The compulsion to buy equities becomes even stronger in the current low interest rate environment for investors seeking positive real rates of return for their long-term objectives. In addition to all of that, we are always just a tweet away from a break in the trade impasse or some other release valve for the current trade tension that can change investor sentiment back to a more sustainably positive trend.

In closing, the reaction by the bond market to the growing trade conflict and its impact on the global economy has been significant and is therefore worth noting. However, there are a variety of influences, mainly political, at work and the long-term, negative impact on businesses may be overstated. In addition, according to Guggenheim, since 1945, the average 5-10% S&P 500 sell off takes approximately one month to recover from. The average 10-20% correction takes five months to recover. Moreover, according to J.P. Morgan, the average intra-year decline in the S&P 500 since 1980 is 13.9%, yet stocks manage to finish in positive territory for the full year approximately 75% of the time and generate positive returns with even higher degrees of confidence over longer periods of time.

Simply put, volatility caused by periodic uncertainty is the price equity investors must pay for higher expected long-term returns. There is little getting around this truth for those seeking long-term growth from equities. Therefore, the best blueprint for this or any environment remains, in our opinion, to diversify with an eye towards fading portfolio risk as your time horizon shortens, invest in quality assets and strategies that can endure whatever the economy throws at them and focus on time in the market as opposed to trying to time markets. As has been said before, investing, at its core, is simple, but it is not easy.

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