Today, the U.S. equity markets experienced their worst day of the year, with the Dow, S&P and Nasdaq all falling roughly -3%. While such days are historically common and not necessarily noteworthy, the lack of volatility experienced over the past several years makes these days seem far worse than we remember them being. What happened?
Markets can become easily spooked by ‘rules of thumb,’ or traditional signals of doom, regardless of the environmental context. In today’s case, it was the inversion of the treasury yield curve when measured by the classic 10-year minus 2-year maturities, the span most often used by economists. Yes, the yield curve has been partially inverted for a while, or ‘humped,’ really, with short-term rates rising higher than the 2-year and 5-year. But the bellwether 10-year treasury note yield had still remained higher—above the fray. Today this ended, as the 10-year treasury rate fell to 1.58%, the lowest level in three years. While there is nothing magical about yield curve shape or moving from flat to inverted (which in this case were caused by strong buying demand for long-term treasuries, driving the 10-year rate lower), inverted yield curves have been strongly associated with recessions showing up in the ensuing 6-18 months. In fact, they’ve been shown academically to be one of the most accurate predictors of recessions. (However, they can also provide false signals, so aren’t foolproof—it’s obviously impossible to know which until after the fact.)
The backdrop hasn’t changed. Signs of economic slowing, shown in weaker manufacturing numbers in the U.S., was well as decelerating data in Europe and Asia, have raised fears of a more widespread global slowdown and end of the current long business cycle. While this weaker data has been largely absorbed by markets, the wildcard of the back-and-forth with the U.S.-China trade negotiations has investors especially on edge, especially with the outcome and timing far from certain and seeming to change by the week. One thing that we can count on is that markets dislike uncertainty more than anything, even more than receiving terrible news, which explains spikes in volatility for risk markets when uncertainty rises.
Valuations for equities appear a bit richer than in years past, but have not looked exorbitant, which reflects the ongoing risks investors have perceived globally. Foreign equities, bearing the brunt of most unfavorable global economic and trade news, are priced at a steeper discount. Bonds, however, despite very strong returns year-to-date due to the rapid declines in interest rates, have begun to appear richer in relative terms. After all, after rates have already fallen, the bar for further declines becomes higher, with chances of a whipsaw in rates equally possible if the worst case scenarios don’t unfold. As always, staying diversified is an investor’s best protection against being wrong on either side during uncertain (or certain) times.
