Weekly Market Commentary March 25, 2019

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The S&P 500 dropped 0.7% on concerns a key economic indicator signaled recession risk was increasing. The global MSCI ACWI slipped 0.5%. The Bloomberg BarCap Aggregate Bond Index soared 0.9% as investors rotated toward fixed-income investments that often perform better when rates decline.

Prior to Friday, the S&P 500 had been experiencing a good week. On Friday, economic data indicated the economy continues to slow, and investors reacted by pushing yield on intermediate- and long-term bonds lower. The decline in yields pushed the 10-year bond yield below the three-month yield, creating an “inverted yield curve.” When the yield curve has become inverted in the past, it has often resulted in a recession in the following six to 18 months. Investors reacted to the increased risk by sending stocks lower on Friday, and the S&P 500 dropped 1.9%.

Key Points for the Week

  • Short-term rates moved slightly above long-term rates creating an inverted yield curve.
  • Stocks moved lower based on this indicator’s ability to predict a recession.
  • Recession risk has increased meaningfully, but it is not inevitable.

Market Analysis

 

 

Friday’s yield curve inversion signals the risks of a recession are increasing, although that does not mean one is certain. As the accompanying chart shows, the yield on three-month Treasury bills is now higher than the yield on 10-year Treasury bonds. A portion of the yield curve first inverted in December. Since then the yields of short-term debt have stayed high while other yields have dropped. This has resulted in a more pronounced dip in yields and a wider range of maturities below short-term rates. Yield curves are normally upward-sloping because investors demand a greater return for bearing additional volatility incurred by tying their money up for longer periods of time.

The indicator is highly regarded because it has predicted the last seven recessions in the U.S., and some believe its triggering means a recession is nearly certain. Research from the Federal Reserve and other sources generally take a risk- or probability-based approach and suggest the signal is an indication of higher risks but not a recession guarantee.

So, what factors will be important in determining whether the increased risk will translate into a recession? The following factors, based on our research, are key to determining how far the economy slows:

  • Labor market strength: The U.S. employment situation has remained very strong, while other indicators have weakened, and continued job creation makes a recession less likely.
  • Depth and length of the yield curve inversion: The higher short-term yields get above long-term yields and the longer the inversion lasts, the more likely the factors affecting interest rates will work their way into the real economy.
  • Federal Reserve policy: The Federal Reserve could cut short-term rates and, assuming long-term rates remain steady, the short-term rate would move back below long-term rates.
  • Other factors: A trade deal between the U.S. and China, resolving Brexit, or other policy changes across the globe could reinvigorate the global economy through increased global growth.

How to react to these risks is a matter of risk and horizon. In the short-run, slowing economic growth puts pressure on corporate earnings, and that becomes a risk to stocks. But the market has weathered numerous recessions and generated strong long-term gains. Market declines may precede a recession, which would make avoiding its effects even more challenging. Given the recent market rally, it is a great time to assess how the increasing risk in equity markets aligns with your long-term goals and risk tolerance.


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