Plunging Interest Rates and a Yield Curve Inversion Drove Stocks Lower This Week
Stocks fell for the third week in a row, as investors worried about weak European economic data, plunging interest rates and fears of a global recession. The S&P 500 fell by 1.03%, while the tech-heavy Nasdaq 100 and the small-cap Russell 2000 dropped by 0.55% and 1.28%, respectively. International stocks also performed poorly, the MSCI EAFE Index (international ex-US and Canada) declined by 1.56%, and the MSCI Emerging Markets fell by 0.83%. In this “risk-off” environment, the safe havens performed very well — gold rallied by 1.00%, and the U.S. Treasury long-bond (TLT) jumped by 4.34% this week.
This week, news headlines drove the stock market to extremes. On Monday, stocks and global interest rates fell because of weak global economic data, and violent protests in Hong Kong (Asia’s financial hub). Investors received some relief on Tuesday when President Trump announced that he would delay the September 1st 10% tariff on some Chinese consumer goods until December 15th, so Christmas would not be negatively impacted.
Unfortunately, on Wednesday, the S&P 500 dropped by nearly 3% as investors panicked when weak economic data (a negative GDP report in Germany, and the weakest Chinese industrial production report in 17 years) led to a plunge in interest rates, which caused the yield on the 10-year U.S. Treasury bond to briefly fall below the 2-year U.S. Treasury’s yield. While other parts of the yield curve inverted months ago, this was the first time the 2’s-to-10’s inverted, which increased the probability of a recession over the next 12-to-18 months.
On Thursday and Friday, the oversold stock market and depressed interest rate rebounded after a German newspaper reported that the fiscally conservative German government might run a $50 billion budget deficit to spur economic growth if Germany fell into recession.
During this “risk-off” week, the 30-year U.S. Treasury bond fell to a record low of 1.92%, and incredibly, the 10-year German Bund dropped to -0.72%. To put these low yields in perspective, in the last recession, the 30-year U.S. Treasury bond and the 10-year German Bund bottomed at 2.50% and 2.92%, respectively (see chart below). Also, nearly $16 trillion of global debt, or 25% of all outstanding debt, has a negative yield, which means that investors who hold to maturity are guaranteed to lose money.
The most basic investing fundamental is that you must assume risk to receive a reward, and the more risk you take, the more potential reward you should receive. This tradeoff between risk and reward is also known as a risk premium.
For example, stocks are riskier than 3-month U.S. Treasury bills, so stocks should have a higher return. Historically, stocks returned about 10% per annum, while the 3-month U.S. Treasury bill returned 3.5%. So, historically, investors received a 6.5% risk premium for investing in stocks instead of the 3-month bills (the risk-free rate).
Since the U.S. is the strongest developed economy in the world, we have low inflation, and we are the world’s reserve currency, investing in our U.S. sovereign debt should offer a low return relative to other developed nations, because we are a safer investment with a very low risk of default.
Currently, the 3-month U.S. Treasury bill yields 1.90%, which is somehow higher than all European sovereign debt maturities expect for the Italian 30-year bond:
GDP 3mo 2-year 10-year 30-year
USA $20.5T 1.90% 1.54% 1.60% 2.08%
Japan $4.97T -0.10% -0.28% -0.23% 0.21%
Germany $3.99T -0.71% -0.89% -0.65% 0.14%
UK $2.85T 0.75% 0.39% 0.48% 1.06%
France $2.78T -0.60% -0.79% -0.36% 0.51%
Italy $2.07T -0.25% 0.17% 1.48% 2.48%
Spain $1.43T -0.52% -0.50% 0.15%
After the “Great Recession,” central banks in the U.S., Europe, and Japan printed $15 trillion to buy bonds and stimulate the economy by pushing interest rates lower, and stocks higher. In our view, the central bank’s policy of “financial repression” did little to help the economy and instead lead to malinvestment, inflated asset values, and wealth inequality. Additionally, after a ten-year economic expansion, the central banks didn’t normalized interest rates, and now, as the economy slows, interest rates have plunged to an irrational level.
Typically, investors cheer falling interest rates because they boost the value of stocks and stimulate economic growth. This week, investors sold shares when interest rates fell because they are fearful that lower rates indicate a weak economy and the possibility that the central banks are out of bullets.
|Our View: The global economy is slowing and Germany — Europe’s economic powerhouse — is on the verge of recession. Market-based indicators – i.e., the yield curve, the price of oil and copper, and the strength of the defensive sectors of the market (Utilities, Reits, Consumer Staples, and Healthcare) – confirm the economy is slowing, and the risk of recession is elevated. Through July, investors bid stocks to an all-time high on the belief that the trade war with China would be resolved and the Fed was beginning a new easing cycle. So far, in August, those assumptions have been challenged – the Fed indicated that their July rate cut was a “midcycle adjustment” and probably not the beginning of a new rate cutting cycle, and the President escalated the trade war with China by announcing a 10% tariff on $300 billion of Chinese goods. While the U.S. consumer remains stout, the global bond market is sending a clear message the there is economic trouble ahead. While the bond, oil, and copper markets indicate a slowing economy, the S&P 500 is less than 5% away from its July all-time high. We believe that stocks offer an inferior risk-reward and we will heed the circumspect message of the bond market.|
Our Tactical Asset Allocation (three to six-month view) is negative. Despite the S&P 500’s 5.3% sell-off in August, we believe that the market has a poor short-term risk-reward. Investor sentiment is neutral, market breadth is weak, and we are in a period of negative seasonality. In our view, the market is in a correction, and we will become more constructive, on a short-term basis, when the market is oversold, investors are pessimistic, and the market’s breadth begins to improve.
Our Strategic Asset Allocation (six-year view) remains underweight equities, overweight bond duration, and long gold. We continue to believe that the stock market offers a poor long-term risk-reward. The upside is limited due to overvaluation and weak earnings growth, while the odds of a recession and a bear market are elevated. At the sector level, we remain overweight the defensive, non-cyclical areas of the stock market, which is consistent with our view that the economy and inflation are slowing.
Our long-term asset allocation remains underweight equities because the market is overvalued, the profit cycle is slowing, and earnings are poised to disappoint as global growth slows and profit margins compress. In our view, the Fed tightened policy too much last year and the recent tariff increases will accelerate the slowdown in growth. We remain concerned that the yield curve indicates that the Fed is too tight and a recession is probable within the next year kaufen viagra in deutschland.
As value investors, we will continue to underweight our long-term equity exposure until the markets offer a favorable risk-reward.