Market Update: Tightening Conditions & Slowing Economies


Market Update Oct 2018

Yesterday’s market pullback was a fairly steep one. The S&P 500 fell by -3.29% and the NASDAQ fell by -4.1% as tech names led the selloff. International markets continued the selloff after the U.S. market close. The main headline from CNBC immediately after yesterday’s market close named this a “stock market slaughter.” Today’s action (as I write this) doesn’t seem to be faring too much better. So, what happened? What was the catalyst that sparked this downturn? Should we be worried? What are the recession indicators?

First, before I begin, it is important to note that the S&P 500 is only -4.4% down from its all-time high. Yesterday’s pullback, while sharp, brings the index back to the same level it was at in July. The last time it saw this big of a drop was…only February.

In a few months time, this will likely be viewed a short-lived pullback and a buying opportunity for many investors and traders. However, I think this market movement provides a great opportunity to go over the current state of the global economy as there are a number of very important events occurring.

SP500_5YR_Oct_2018There was no single catalyst that caused this pullback, though there are certainly a few things we can point at. The main reasons are the following:

  • Higher bond yields
  • Tightening monetary conditions
  • Slowing global growth

Bond Yields on the Rise

Interest rates have been rising for some time now and the yield curve has been flattening. The 10-Yr Treasury bond is currently yielding 3.22% and the 2-Yr is yielding 2.88%. Both of these are up massively over the past year, up +94bps and +137bps respectively.

10 Yr Treasury Oct 2018As interest rates rise, “safer” bonds become more appealing to investors than “riskier” asset classes, such as U.S. equities. And this has certainly been the case recently, especially as U.S. stocks have had a fantastic run. However, central banks are tightening financial conditions by raising interest rates and slowing/ending their bond-purchase programs. This has major implications and this will likely continue to slow global expansion.

Central Banks No Longer Printing Free Money

President Trump recently stated, “I think the Fed is out of control,” and that the Federal Reserve “has gone crazy.” There is blame that the recent market volatility is due to the Federal Reserve raising interest rates. However, what is crazy is that the effective fed funds rate is only at 2.00% to 2.25% after years of free money. We have lived in a period of extremely low interest rates for nearly 8 years.

Effective Fed Funds Rate

This period of near-zero interest rates has persisted for much longer than needed. Not only has the Federal Reserve engaged in the practice keeping rates extremely low, but so has the European Central Bank, the Bank of Japan, and the People’s Bank of China. The purpose behind this practice was to raise the price of risk assets in the wake of the Great Financial Crisis. It worked, but it has also allowed the amount of global debt to explode.

The problem with this approach is that the Federal Reserve has missed a lot of great opportunities over the years to raise interest rates. The Fed Funds Rate should be double what it is today. The longer we have low interest rates and an accommodative monetary policy, the more likely we are continuing to accelerate this debt problem. By not raising interest rates at opportune times in the past, the central banks have essentially kicked the can down the road. However, the low interest rate party finally seems to be winding down as central banks have started to become less accommodative. The global central bank balance sheet decreased by over $500B dollars since March 2018.

Source: ECRI

The most important upcoming central bank catalyst is that the European Central Bank intends to end its asset-purchase program by the December 31, 2018 and to begin raising rates by 2019. Furthermore, the Bank of Japan has conceded that its monetary policy (which was extremely ambitious and controversial) has not worked. In fact, it has stated that it hopes to raise rates twice this year.

Slowing Global Growth

A few months ago, I talked about the dichotomy of the United States outpacing the rest of the world. This fact is still true today, even with the recent market volatility. The U.S. economy is currently experiencing a slowdown of economic growth, but is not at risk, at least in the near-term, of entering into a recession. We experienced an economic expansion peak near the end of Q1 2018 and have since tapered off.

US Weekly Leading Index
Source: ECRI

The international markets, however, have experienced a moderate slowdown, led by the emerging markets. It would not come as a surprise if the emerging markets is currently in a recession and the developed world (except for the U.S.) would soon enter into a recession. The equity markets have already priced in this possibility.

Conclusion

The developed markets, outside of the U.S. and the emerging markets are experience a garden-variety economic downturn. Whether or not this turns into a more serious slowdown remains to be seen. The U.S., on the other hand, is NOT likely to enter into a recession anytime soon. The vast majority of the leading indicators suggest there will be no economic contraction within the next 12-18 months. Though, we are currently seeing a slowdown of economic growth.

The recent market volatility can be attributed to a number of factors, but the most likely ones are rising interest rates, tightening conditions, and an international slowdown. It is imperative that as an investor that you do not make an impulse decision and sell out of all risk assets. There are numerous research pieces that come to the same conclusion within this sector: stay invested and stay remain diversified. Work with a financial professional to ensure that you are correctly positioned in today’s marketplace. If you are looking for a financial advisor to discuss market trend updates or other financial advice in San Diego, we would be happy to discuss your financial situation.

 


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