The week in review: positive developments in the trade spat with China, U.S. sanctions Russia, the FBI raids the office (hotel room, safety-deposit box, phones and home) of President Trump’s lawyer, House Speaker Paul Ryan announces he won’t run for re-election, Facebook’s CEO testifies to Congress about personal data security of its users, tweets about imminent strikes on Syria with “new and smart missiles” followed by delivery of such missiles, and the Congressional Budget Office updated their forecast that U.S. debt will reach 100% of annual GDP by 2027 – a level last seen during World War II. It’s doubtful that the last news item moved markets, but it is probably the most important event from last week. The year 2027 is a way off, but history has shown that countries with debt levels at or above 100% of GDP are subject to slower economic growth. Slower economic growth translates into slower profit growth, which translates into lower investment returns across all asset classes. Someday investors will care the U.S. has a debt problem… just not today.
For the week, equity markets rallied with domestic stocks (S&P 500 +2.0%) outperforming international stock indices (EAFE +1.2%, China +0.5%, Emerging Markets +0.7%). Amongst domestic stocks, small cap (Russell 2000 +2.4%) and technology (Nasdaq +2.8%) were the best performers. Last week’s rally pushed the S&P 500 to essentially breakeven on a year-to-date performance basis. Yields on the short end of the credit curve jumped last week, with a noticeable flattening as longer-dated bonds barely budged. The yield spread between 2-year notes and 10-year bonds ended the week at 46.6 bps, as the curve creeps closer to inverting. The threat of attacking Syria proved a boon for precious metals (gold +1.0%, silver +1.7%) and the energy complex as the price of WTI Crude jumped +8.6% to $67.39 per barrel – its highest level since November 2014.
For more detail on weekly, month-to-date and year-to-date asset class performance, please click here.
Volatility Cyclicality – Following historically low volatility in 2017, the daily (and sometimes hourly) swings in equity markets prices are drawing a lot of attention. Markets have always been subject to idiosyncratic “headline risk” – unexpected news causing investors to reassess the future value of their portfolio holdings. And the news is flying fast and furious this year from the potential for a trade war with China to regulatory scrutiny of significant technology companies to developments around the President’s alleged misdeeds. It’s not as if the last several years were devoid of news events, but these idiosyncratic market risks were overwhelmed by an ultra-accommodative monetary policy which, by design, inflated the value of risky assets. Global quantitative easing and historically low-interest rates largely immunized markets from headline risk and volatility.
However, the structural underpinnings of the low volatility environment are now giving way as the Federal Reserve removes accommodation in response to decent economic growth. From a historical perspective, rising volatility should not be surprising late in the business cycle, which is where we find ourselves today.
Indeed, equity market volatility follows a reasonably predictable pattern that correlates with the business cycle and the shape of the yield curve. In the early stages of a cycle (i.e., when the economy is emerging from a recession), volatility tends to be low due to improving business conditions, cheap and available credit, and low inflation – conditions that allow the Federal Reserve to remain on the sidelines keeping monetary policy accommodative. Conversely, late in the cycle these conditions reverse as the Fed raises interest rates to cool the economy and prevent inflation from exceeding its long-run target of 2%. The Fed’s actions directly impact the short-end of the yield curve (bonds that mature within two years) pushing yields higher, while longer-dated bond yields tend to be less reactive. This combination results in a narrowing of the spread (also known as yield curve flattening) between the 10-year bond yield and shorter-term yields such as the Fed Funds Rate.
A tightening of monetary policy increases the risk of recession as the Fed Funds Rate is a blunt tool whose impact on the economy is lagged. Indeed, most recessions have been caused by an overly aggressive Fed whose actions squelch economic growth as rising interest rates curtail corporate profitability. Lower profitability results in reduced hiring, creating a positive feedback loop in the economy: lower profitability à less hiring à reduced consumption à lower sales à lower profitability à less hiring, and so on.
The spread between the Fed Funds Rate and the 10-year US Treasury provides a good indication of the state of monetary policy. When monetary policy is easy, the spread is wide, and when monetary policy is tighter, the spread narrows. As the chart below indicates, periods of tighter monetary policy (represented by a low yield spread on the left-hand axis) are associated with higher volatility as captured by the level of the VIX Index. Keep in mind when viewing this chart that the right-hand axis showing the level of the VIX Index is inverted (higher VIX levels are represented lower in the diagram).
Source: Merrill Lynch
Using history as a guide, we are at a point in the business cycle where volatility will be structurally higher. News headlines will still impact the day-to-day movements, but the absence of headlines is unlikely to cause volatility to meaningfully subside as the Fed continues to tighten monetary policy.
Speaking of Tightening – Although Federal Reserve Chair Jerome Powell has stressed that the Fed is not on a pre-ordained path to higher rates and that each rate decision is “data dependent,” the Fed is apparently concerned about future inflation. In fact, analyzing speeches from the Fed governors shows that the Fed is more concerned about inflation now than at any point since the Great Recession.
Absent a meaningfully economic shock (which is different from an isolated stock market shock), those that doubt the Fed will continue to raise rates may want to reconsider their position.