With a week subdued by a day of mourning, traders hoped market volatility would follow suit: it did not. In less than three trading sessions the S&P 500 traded down five percent, the Dow Jones Industrial Average lost more than 1,400 points and small cap stocks lost 6 percent. We believe this market volatility is not over as investors adjust to a new paradigm of deceleration in a still expanding economy, the prospect of higher short-term interest rates and uncertainty surrounding trade and tariff policy.
We see three factors most affecting the markets in the near-term:
First, the sharp rise in the equity markets at the tail end of November, the largest six-day gain in six years, drove the S&P 500 up 6.1 percent. This put the market in a short-term “overbought” condition. In other words, money flowed in faster than market participants believed prudent and they overshot their target. Quick profit taking normally pulls the markets back into equilibrium but, in the case of this week, the markets again overshot, creating an “oversold” condition. In the last several years, this oscillation in the markets has been in a very tight range and has not been worrisome to investors. In fact, as we get late in the cycle, it is normal for market volatility to increase. However, our fundamental posture remains unchanged: we believe a recession is not imminent. While it is true that we expect economic growth (GDP) to slow next year in the United States, China and Europe, at present, a recession is nowhere in sight, and economic reports released in recent weeks has served to clearly support this fundamental view.
The second factor affecting the market’s volatility is the uncertainty surrounding trade and tariffs with China. Over the weekend, the White House boasted that the G-20 Summit generated substantial progress on trade talks and that a temporary truce with China had been reached. The ensuing rally reversed when various news outlets highlighted contradictory commentary from both the U.S. and China, suggesting that minimal progress had actually been made. We continue to believe that de-escalation in the trade tensions with China is in the best interest of all involved.
Lastly, this week saw an inversion in 3 Year and 5 Year U.S. Treasury yields such that the yield on the shorter maturity was slightly higher than the longer. Understandably, this made markets nervous as materially inverted yield curves have preceded past recessions. However, the timing of the inversion is more telling. Last week, Federal Reserve Chair Jerome Powell’s dovish commentary to a gathering of the Economic Club of New York brought inflation and an end to rate hikes to the forefront of bond traders’ minds. Since then interest rates have fallen for longer maturity bonds.
Week in Review and Our Takeaways
Equity market volatility continues to persist. The S&P 500 5 percent this week
Trade negotiations are murky, and progress is far from linear
The yield curve inversion is merely an anomaly impacting a very small portion of the yield curve and we believe this does not portend something more sinister