The last three months of 2018 was a difficult period for the stock market. The volatility was a gut check we hadn’t felt in a decade. But since the low in December, Wall Street has climbed the wall of worry and mostly recovered.
In fact, if the S&P Index climbed 3% from where it is today, we would be at a new all-time high.
Our year-end newsletter shared that we were cautiously optimistic. As we look around inflation is low, companies are doing well and the job market is strong but we have concerns to revisit (1) international trade disputes and (2) the inverted yield curve. Both are still important and worth our attention, particularly the inverted yield curve.
When a country doesn’t feel it is equally benefitting from a trade agreement, new agreements need to be negotiated. These negotiations can take several years and be highly disruptive to the flow of goods and services in the short term.
Usually they result in barriers to trade, such as tariffs. Tariffs are a tax on anything exchanged between nations and thus slow global growth.
If/when the UK leaves the European Union (and it seems likely), both sides will need to negotiate new trade agreements and it could mean higher barriers to trade, capital flows and labor mobility which puts pressure on output and jobs.
Then the issue of the U.S.-China– which has additional complexities because China’s economic model systematically tilts the playing field in favor of Chinese companies domestically and globally. It blurs the lines between the public and private sectors which makes a trade agreement difficult to enforce. ²
A resulting deal should address the issues in a free-market manner and strengthen the global trading system. Aiming to eliminate the imposed tariffs when specific benchmarks are met with a snapback provision in the event of noncompliance. The sentiment has been optimistic, but we are waiting for things to be worked out.
Every country is motivated to protect their self-interests so trade disputes have and always will exist. These issues can have an effect of slowing global growth but as investors we don’t believe it should be a basis for changing investment allocations.
The Yield Curve
This topic sounds complicated, but it’s an important indicator to pay attention to as it has been predictive of many economic downturns.
Our goal is for investors to understand what it is, how they may be impacted and what we are doing to prepare for the possibility of a weaker stock market.
To start, the yield curve is the relationship between short-term and long-term interest rates. Typically, longer rates are higher than shorter rates because it is riskier to invest or lend money for longer periods.
We could use the example of interest rates on a 15- versus 30-year mortgage; a bank takes on more risk by extending credit for longer periods of time and thus collects a higher interest rate from the borrower.
Critical to understanding the difference between long-term and short-term rates is that the Federal Reserve sets short-term rates.
“When the economy is weak, the Fed tries to keep rates low to boost growth. When the economy is strong, the central bank pushes rates up, both to head off inflation and to give itself room to cut in the next recession.” ¹
They have done just that. In 2008 the Fed reduced rates to zero to aid in the recovery from the 2008-2009 recession. This was successful and years later (2015) the Fed began to gradually raise short-term rates, now 2.25%.
On the other side, long-term rates are not set by a governing body like the Fed, but rather are a reflection of expected inflation. Inflation hasn’t been increasing because technology has continued to push down the prices of goods and services. As a result long-term rates haven’t increased.
As the Fed increased short-term rates the difference between the two narrowed. In fact, short-term rates are currently higher than long-term rates, an inverted yield curve. An inverted yield curve has historically signaled the coming of a market decline and possible recession in the coming 12-24 months. See Graphic 1 (right) and 2 (back)
If history is repeating and a recession is coming, the challenge is when and to what degree (if any) should we adjust portfolios.
This may be especially challenging this time because if a market downturn occurs, we don’t believe it will be anywhere near as deep nor as long as the past 2 downturns because we don’t see the type of excesses that were present in the prior troublesome period of 2000-2009.
First in 2000 the tech bubble burst after prices for technology skyrocketed (out of control) and then crashed. A few years later with lax lending practices, real estate prices rapidly rose and then crashed. We don’t see anything like these bubbles today.
What’s An Investor to Do?
We believe there are three types of risk that every investor should consider. One or all of these could apply to you.
Impairment: You need to sell stocks to withdraw funds at a time when the stock market has declined significantly. This is the most important risk to consider because if you sell stocks after a decline occurs it could be difficult to overcome the loss. Discomfort: You do not need to withdraw funds from your portfolio but seeing your balance lower than it was is uncomfortable causing stress or anxiety. The thought of the balance going down further adds to your concern. Opportunity: Owning stocks will usually reward investors with higher returns over time. Those returns help protect you from rising prices (inflation) and allow an opportunity to enjoy the added wealth.
Everyone should have a long-term strategy, similar to making a long boat trip. With a plan on how to reach your destination and how to overcome what may occur along the way (storms).
After considering the three risks, it helps to have professional guidance in creating a route and how to effectively adjust the sails. Similarly, adjustments in your stock exposure may be needed to adequately meet withdrawal needs and/or overcome uncertainty.
Legal Information and Disclosures This memorandum expresses the views of the authors as of the date indicated and such views are subject to change without notice. Samara has no duty or obligation to update the information contained herein. Further, Samara makes no representation, and it should not be assumed, that past investment performance is an indication of future results. Moreover, wherever there is the potential for profit there is also the possibility of loss.
This memorandum is being made available for educational purposes only and should not be used for any other purpose. The information contained herein does not constitute and should not be construed as an offering of advisory services or an offer to sell or solicitation to buy any securities or related financial instruments in any jurisdiction. Certain information contained herein concerning economic trends and performance is based on or derived from information provided by independent third-party sources. Samara Capital (“Samara”) believes that the sources from which such information has been obtained are reliable; however, it cannot guarantee the accuracy of such information and has not independently verified the accuracy or completeness of such information or the assumptions on which such information is based.
This memorandum, including the information contained herein, may not be copied, reproduced, republished, or posted in whole or in part, in any form without the prior written consent of Samara.