With the holiday season upon us, we find ourselves reflecting on our many blessings throughout this past year. We thank you for your loyalty, and we look forward to serving you in the year ahead. May your New Year be filled with good health, great memories, and success in all your endeavors.
A few thoughts about the stock market:
- We think computer-driven trading algorithms have greatly contributed to the tremendous volatility we have recently seen. Trading firms (‘Algos’) often buy index ETFs to gain broad exposure to the stock market, and selling these large, liquid index ETFs amounts to ‘sell everything.’
- Investors have become obsessed with the yield curve and fear an inversion (short rates higher than long rates). We are close to inversion but have not yet reached that point. It is true in recent history all recessions have been preceded by an inverted yield curve, but all inversions do not result in recession.
- This week’s focus will be on Wednesday’s FOMC meeting. Investors are still looking for a 25 bp increase in the Fed funds rate, but expectations for 2019 have been throttled back to just two more increases. The language they use in their announcement will be key. Any surprises will have the potential to swing the market sharply in either direction.
Investors across the globe have struggled to make money this year. As of the end of October, 89% of global financial indexes were negative in dollar terms for the year. Only 29% of indexes are down in a typical year.
The end of central bank accommodation (quantitative easing combined with zero or negative short interest rates) has given way to a new, more chaotic, market that includes interest rate hikes, central bank balance sheet unwinding (QT) and increasingly anxious investors. Several recent trend reversals are worth scrutiny:
- The yield curve (10-year T-notes minus two year) has flattened dramatically of late. The spread narrowed to 9 basis points last week, down from 37 in late November. The curve now threatens to “invert” as short rates continue to be under pressure to rise while longer-dated yields decline.
- Long predictable correlations (yields lower, credit spreads tighter) are breaking down as credit spreads, especially among high yield sectors and leveraged loans, are widening regardless of market yield direction.
- The Trump administration’s vocal dissatisfaction with recent Fed interest rate policy has upset already apprehensive investors effectively refersing the administration’s goal of managing (if not coaching) markets through twitter. Investor reaction is becoming less and less predicatable.
- High yield credit spreads have recently widened over one percent against like maturity Treasury notes while the ten year Treasury has rallied to near its lowest level in over three months. Longer-dated Treasury notes appear to be benefiting from a “flight to quality.”
So what’s the point?
Bond market “normalization” may be responsible for much of the elevated volatility, pressure in commodity prices, rolling stock market corrections and the worldwide contagion associated. Demand for high yield and leveraged loans is declining as yield-hungry investors grow disillusioned with losses and attempt to distance themselves from risky investments. November’s speculative-grade corporate issuance slowed the most since early 2016 reflecting the slack.
Domestic bond investors are feeling the pain of losses as rate normalization runs its course. Risky fixed-income assets are becoming more toxic and the debt cycle’s conclusion may take several years to play out. 2018 looks to be the first year in a decade to post losses across much of the fixed income universe and 2019 may be worse. We will continue to employ a very conservative fixed-income strategy for client accounts.