Putting the Recent Market Declines in Context

The uncertainty over trade disputes between the U.S. and China has been reflected in recent market activity. Equity markets fell sharply on Dec. 4 as investor optimism faded over the recently struck 90-day tariff truce between the U.S. and China. The S&P 500 Index and Russell 2000 Index slumped -3.2% and -4.4% for the day, respectively.

Tuesday’s activity marked a sharp reversal from just a day earlier, as equities had gained more than 1% on Monday over hopes that the U.S. and China might find an amicable solution to long-running trade disputes. Over the past year, investors have become increasingly concerned that the U.S.-China trade impasse could escalate into a broader trade war, which could have negative implications for global growth and notably at a time when global economic data has been weakening.

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Adding further to Tuesday’s declines, portions of the Treasury yield curve recently inverted, with two-year and three-year yields slightly exceeding the five-year yield for the first time since 2007, stoking investor concerns of a looming economic slowdown.

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Why does an inverted yield curve matter?

For a healthy and growing economy, longer-term rates are higher than shorter-term rates as investors demand greater compensation for the risk of inflation and interest rate increases. When the yield curve inverts, it generally signals that investors are concerned that economic growth will slow down from current levels.

Historically, an inverted yield curve has been a strong predictor of future recessions, explaining why investors place such an emphasis on the shape of the yield curve. Research by the Federal Reserve Bank of San Francisco has shown that an inverted yield curve (in this case, the difference between one-year and 10-year Treasury yields) “has correctly signaled all nine recessions since 1955 and had only one false positive, in the mid-1960s, when an inversion was followed by an economic slowdown but not an official recession.”

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Similar research by the Cleveland Fed has shown that an inversion between three-month and 10-year Treasury yields has preceded each of the past seven recessions, though that spread has yet to invert (currently at 0.50%). Using the yield curve as a recession predictor, the Cleveland Fed currently estimates the odds of a recession within the next year at only 20%.

For additional perspective, a recent Reuters poll of economists pegged the probability of a U.S. recession within the next two years at approximately 35% with U.S. trade policy cited as one of the economy’s biggest downside risks.

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Many investors assume that an inverted yield curve implies an imminent recession though that is not necessarily the case. The San Francisco Fed’s research notes that the delay between an inverted yield curve and a subsequent recession has ranged between six and 24 months.

It is also interesting to note that a yield curve inversion does not imply negative market returns immediately thereafter. In fact, when looking at data from the past five recessions, the S&P 500 Index still produced positive returns following an inversion.

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In addition to mounting concerns over global growth and interest rates, recent equity market declines have also been compounded by a notable selloff within the technology sector, which had meaningfully contributed to U.S. equity market returns over the past several years. Big technology companies (such as the FAANGs) have come under increasing pressure in recent weeks as investors have grappled with mixed earnings and less optimistic outlooks, calling into question the valuations of previous high-flying stocks.

Some investors fear that the S&P 500 Index may be harder pressed to produce significant gains going forward should the technology sector no longer be a top performer.

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While the news headlines may highlight the severity of the recent pullback, the reality is that recent market declines are well within the norm of longer-term market cycles. Since January 1980, the S&P 500 Index (U.S. Large Cap stocks) has experienced an average intra-year decline of approximately 14%. Over that period, the index had an intra-year decline of more than 10% in nearly half of the years observed and had an intra-year decline of more than 15% roughly a third of the time. Nevertheless, the S&P 500 Index still produced positive returns in 29 of 38 calendar years despite those notable declines.

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The chart above serves as a practical reminder that investors who sold following a sharp decline would have likely sacrificed significant long-term gains, having missed out on the subsequent market recovery.

We recognize that market pullbacks such as those we have recently experienced can be trying times for investors. During periods of heightened market volatility, investors may feel the urge to make sweeping portfolio changes, though such moves are often ill-timed and can significantly impair the effectiveness of a prudently designed investment plan. Investors should periodically revisit long-term objectives and time horizon to evaluate whether portfolios are appropriately positioned with risk tolerance.

We do not find compelling reasons at this time that would justify overriding our asset allocation methodology despite elevated uncertainty. We continue to believe that investors should be patient and adhere to a well-constructed, diversified investment portfolio anchored to long-term goals and time horizon.

If you would like to discuss your portfolio in light of your long-term objectives and risk tolerance, contact an advisor at Fi3 today.