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While capital markets have advanced off of the late December lows, few of our objective market measures indicate that the bottoming process is complete. The list of potential sources for further market gyrations is long—including slowing global economic growth, monetary and trade policy errors, investor complacency, overbought asset classes, and lower revisions to corporate earnings.
Monetary (Fed) and trade (China) policies are being decided by two small groups of decision makers who have been somewhat inconsistent in their messaging.
While there has been little clarity on the true direction of trade talks with China, the Federal Reserve’s 180-degree reversal from December to January has helped assuage investors’ fears of a major monetary policy mistake. Historically, stock and bond market performance has been mixed when the Federal Reserve opts to pause interest rate hikes. Recently, the market reaction has been one of relief as long-term interest rates dropped and stock prices climbed higher. That relief may be temporary if long-term interest rates dip below those seen on shorter- term bonds.
This phenomenon, known as an inverted yield curve, has preceded several past recessions. The bottom section (red) in the chart below shows the difference between 10-year treasury yields and 2-year bond yields. A value below zero indicates an inverted yield curve. The vertical gray shading in that section indicates past domestic recessions.
As you can see, all five of the last recessions were preceded by an inverted curve. The right side of the chart illustrates a curve which is flattened and close to inversion. As we’ve noted in the past, the pace of movement by the Fed is critical. If further interest rate increases are delayed, the risk of an inverted yield curve due to a rise in the short end is greatly diminished.
While our domestic economy shows little threat of recession in the short term, the Ned Davis Research Global Recession Probability Monitor is elevated. That probability is consistent with global slowdowns, as shown in the chart below. The question the markets want to be answered is will the US will continue its economic growth in the face of slowing global growth?
Although prices have rebounded from December lows, there remains substantial uncertainty in most of our critical areas of concern for continued volatility. This concern warrants continued defensive posturing. News of ongoing policy progress and/or economic bright spots could change our opinion and would call for a quick shift to neutral or overweight stock allocations in our client accounts.
The economic forecasts set forth in this material may not develop as predicted and there can be no guarantee that strategies promoted will be successful.
All indices are unmanaged and cannot be invested into directly. Unmanaged index returns do not reflect fees, expenses, or sales charges. Index performance is not indicative of the performance of any investment. Past performance is no guarantee of future results.
Bonds are subject to market and interest rate risk if sold prior to maturity. Bond values will decline as the interest rates rise and bonds and subject to availability and change in price.