July continued the major themes of 2018 – the S&P 500 remains focused on the growth story, and has drifted higher. Meanwhile, the rest of the world struggles mightily. Turkey and Argentina are facing full-fledged currency panics. The domestic Chinese stock market is plummeting, and the yuan has had one of its sharpest sell-offs in years. In other words, the price of Amazon stock says all is well – everything else says, well, it’s a jungle out there. In the U.S., eyes are on the next meeting of the Fed, as they are expected to announce their next rate hike on September 26th. The Fed’s preferred gauge of inflation, the personal consumption index (PCE) just touched its 2% target, historically anemic but it gives hope to inflation bulls. In addition, Trump has announced tariffs on an additional $200 Billion of Chinese imports, and the market is watching to see if these will actually be implemented in the first week of September as planned.
Stocks & Bonds
The U.S. stock market edged upwards in July. Earnings season has revealed double-digit growth for many U.S. companies, although this was often a 1-time effect from the tax cuts. Outside the U.S. is a different story, as developed nation stocks are down slightly for the year, emerging market stocks are down over 6%, and most foreign currencies have weakened relative to the U.S. dollar. By the numbers:
Oil prices declined almost 7% in July as global inventories stopped declining and stabilized somewhat. For the year they are still up almost 12%. The safe haven of gold, which is a non-interest-bearing investment, usually struggles in a rising rate environment, and this time is no different. The yellow metal fell over 2% in July and is down just over 6% year-to-date. Rising rates and struggling foreign stock markets are also positive for the dollar. The dollar index was slightly negative in July, losing 0.15%. However, it remains up 2.57% year-to-date.
The ISM Manufacturing PMI in July was 58.1%, slightly lower than the June reading, but still firmly in expansion territory. The non-manufacturing, or services, index came in at 55.7%, also weaker than the prior month, and also indicating continued expansion. After growing at an annual rate of 2.2% in the first quarter, the Commerce Department estimated that the U.S. economy grew at an annual rate of 4.2% in the second quarter.
The National Association of Realtors reports that existing-home sales in July were 0.7% lower than in June, and are 1.5% lower than they were a year ago. The median home price rose 4.5% to $269,600 from a year ago. Median home prices have been rising for the past 77 months. The average 30-year mortgage rate in July was 4.53%, down slightly from the 7-year high of 4.59% attained in May. Distressed sales (foreclosures and short-sales) were 3% of total sales in July.
The financial news has increasingly carried articles about the yield curve, and its possible upcoming inversion. A ‘yield curve’ could mean the difference between any two types of bonds, but in general the yield curve discussion involves the difference in rates between the 2-year and 10-year Treasury bonds. At market close yesterday, the rate on the 2-year bond was 2.64%, and the rate on the 10-year bond was 2.86%. The difference between these two, 0.22%, is the yield curve. The graph below shows how this difference has changed over the last several decades (shaded areas are recessions). Usually, there is a percentage or two difference. After all, loaning money for 10 years rather than 2 involves significantly more risk and uncertainty. There are 8 years of unknown inflation, unknown taxes, unknown politics. So common says that if the rate on the 2-year is 2% or 3%, then the rate on the 10-year should be 4% or 5%. Why on earth would the market only ask for 0.22% difference to take on 8 additional years of uncertainty? That makes no sense!
There are a variety of forces that make this happen. Few of them are good news. When the yield on the 10-year drops below the yield on the 2-year we say it has inverted. This has happened before every recession since World War II. However, it has also happened occasionally, and not predicted a recession. It’s the old ‘every cow is an animal, but not every animal is a yield curve’ logic. Still, a compressing yield curve, or a negative yield curve, is a symptom of turbulent market forces.
In plain terms, a yield curve inversion means that short-term uncertainty is very high, and short-term borrowing is very high. Somewhere in the world, short-term borrowers who live on revolving debt (leveraged governments and companies) are suddenly in trouble. This happens on a macro scale, although the anecdotes are easy to remember. Enron stock started dropping just a few months after the yield curve inverted in 2000, and filed for bankruptcy the following year. Lehman Brothers stock started dropping 11 months after the inversion in 2006, and also filed for bankruptcy the following year. Both of those companies were overly leveraged – companies with modest debt also had bad years, but they did not have to take bankruptcy. So far, rising rates have caused extreme stress in Turkey and Argentina, although so far* no major corporation has followed in the footsteps of Enron and Lehman Brothers.
During a yield curve inversion, the same uncertainty that drives 2-year rates higher is driving 10-year rates lower, as stock market investors sell equities and buy the security of the U.S. Government 10-year bond. This dynamic has mainly happened with international stock investors, with proceeds from many foreign stock sales going into U.S. Treasury bonds. So far, there has not been commensurate selling in the U.S. stock market.
At its current trajectory, analysts think the yield curve could invert by the end of this year, or sometime in 2019. Of course, it may simply get close to inverting, and then reverse course. And if it does invert, it could be one of those rare times when recession and stock market correction does not follow. As with anything else in the field of economics, past performance does not predict future results.
Still, for the long-term investor, turbulence between the 2- and 10- year Treasury note is important information, and should be part of any risk analysis when looking at portfolio diversification.
And as always, please feel free to forward this to friends and family.
*Despite one of the healthiest car markets in years, Ford debt was recently downgraded to one notch above junk. I am not predicting catastrophe for Ford, just pointing out that high debt continues to be a problem for many companies, even as the economy is recovering.
www.standardandpoors.com – S&P 500 information
www.msci.com – MSCI EAFE information
www.barcap.com – Barclays Aggregate Bond information
www.bloomberg.com – U.S. Dollar & commodities performance
www.realtor.org – Housing market data
www.bea.gov – GDP numbers
www.bls.gov – CPI and unemployment numbers
www.commerce.gov – Consumer spending data
www.napm.org – PMI numbers
www.bigcharts.com – NYMEX crude prices, gold and other commodities
https://fred.stlouisfed.org/series/T10Y2Y#0 – Yield curve chart
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