|S&P 500 Index||2,640.87||-2.69%|
|Russell 2000 Index||1,529.43||+1.12%|
|MSCI Europe, Australasia, and Far East (EAFE) Index||2,005.67||-2.24%|
|MSCI Emerging Markets Index||1,170.88||-2.03%|
|Bloomberg Barclays U.S. Aggregate Bond Index||2,016.48||+0.64%|
|Bloomberg Barclays Municipal Bond Index||1,154.54||+0.37%|
|Source: Bloomberg. Equity indexes are price-only and do not include the impact of dividends. Bond indexes are total return.|
“March Madness” refers to the two-week long NCAA Division I men’s basketball tournament. The tournament usually provides a number of exciting upsets and Cinderella stories. There was also a bit of “madness” during the month of March, let alone the quarter, as volatility returned in a major way to global financial markets.
Equities struggled towards the end of the month as investors assessed the possible ramifications of a tit-for-tat trade dispute with China and the threat of new regulations within the technology sector. The S&P 500 fell 2.7% for the month led by declines in bellwether technology stocks such as Google parent, Alphabet, Inc. (-6.6%) and Facebook (-4.6%).
The S&P 500 fell 1.2% overall for the first quarter, surrendering all gains from the white-hot start to the year when the index climbed 5.6% in January. This represented the first quarterly loss in the past ten quarters —an impressive run for sure. Only two out of eleven S&P 500 sectors posted gains: Technology and Consumer Discretionary.
While equity volatility as measured by the CBOE Volatility Index (VIX) was rather tame in March, rising only 0.6%, it surged during the quarter by 81%. This was driven by investor concerns over trade policy, the direction of the Federal Reserve’s monetary policy, and the unwinding of trading strategies tied to the persistence of low volatility in financial markets. According to Ned Davis Research, after only eight trading days of 1% moves in either direction during 2017, the S&P 500 posted twenty-three such days during Q1. There were zero days of -2% moves in 2017, but five alone in Q1.
One bright spot in March was the 1.1% gain in U.S. small company shares as measured by the Russell 2000 Index. Smaller companies derive a greater percentage of sales domestically thus providing some degree of respite from the impact of trade-related concerns affecting the giant multinationals. For the quarter, the index fell 0.4%.
International equity markets were weak in March with the MSCI EAFE Index, led by Europe, and the MSCI Emerging Markets Index down by 2.2% and 2.0%, respectively (as measured in U.S. dollars). For the quarter, the EAFE fell 2.2% but Emerging Markets was able to grind out a 1.1% gain on the strength of higher commodity prices.
The yield on the benchmark 10-year U.S. Treasury note fell by 12 basis points (0.12%) to end the month at 2.74% as investors appeared to reassess the prospects of stronger economic growth and the threat of rising inflationary pressures. Interestingly, the yield fell even as President Trump signed a $1.3 trillion omnibus spending bill that suggests a greater supply of U.S. Treasury debt for the market to absorb. For the quarter, the yield increased about 33 basis points. This represented the largest quarterly rise since the fourth quarter of 2016.
The Bloomberg Barclays U.S. Aggregate Index - a broad-based benchmark of the U.S. taxable, investment-grade bond market—rose 0.64% in March as rates eased but fell by 1.5% for the quarter.
Municipal bonds, as measured by the Bloomberg Barclays Municipal Bond Index, modestly climbed by 0.4% in March but fell by 1.1% for the quarter.
The spot price of gold increased by 0.5% during the month and by 1.7% for the quarter, its third consecutive quarterly increase.
Despite the decline in most equity indices during the quarter, it is important to maintain perspective. Over the past 12 months ending in March, the S&P 500 climbed an impressive 19.4% (not including the contribution of dividends).
A bear market, defined as a 20%+ correction in equities, typically occurs when the U.S. economy is entering into recession. Historically, one of the most reliable indicators of an upcoming recession is an inversion of the U.S. Treasury yield curve. A yield curve plots the yield of bonds having similar credit quality but differing maturities. The yield curve spread (YCS) is measured as the difference between long-term and short-term yields.
There are numerous yield curve spreads but the spread between the 10-year and 2-year U.S. Treasury note is used frequently since the 2-year note is considered most sensitive to changes in Federal Reserve monetary policy. Exhibit 1 highlights this spread since the beginning of 2015. On March 29, it hit its lowest level since September 2007 at just under 47 basis points, as the 2-year Treasury yield reached its highest peak since August 2008.
Why has the YCS been so effective at predicting recession? There are several explanations (perhaps the topic of a future commentary) but a powerful reason is an inverted yield curve indicates financial disintermediation—it interrupts the process by which financial institutions such as commercial banks earn a positive spread between the short-term borrowing rate and the long-term lending rate.
A recent flattening of the YCS has raised concerns of an imminent inversion and possible signal of recession in the next 12 months. Inversion - where short-term rates exceed long-term rates - has preceded every recession since 1955.
But has the YCS lost its forecasting power? Many voices, including policymakers at the Fed, claim things are different this time. Fed Chairman Jerome Powell did so in his first press conference as the head of the central bank last month. Powell said that with inflation at relatively low levels, the YCS is no longer the reliable recession signal that it once was.
|Exhibit 1: 10/2 Yield Curve Spread|
With this view, it is not surprising that Powell is comfortable with the Fed hiking the federal funds rate target an additional three times by year-end.
Powell’s views were endorsed by the Federal Reserve Bank of Cleveland’s President, Loretta Mester, and the following week when she said that a flatter yield curve is not a signal of a weaker economy.
However, the Fed risks an inversion if long-term rates do not rise in concert with increases in the federal funds rate target.
The Federal Reserve Bank of New York maintains a statistical model that attempts to predict the probability of recession one-year ahead. The model uses the 10-year note minus 3-month bill YCS. At the last update in early March, the model suggested a 9.1% probability of recession in the next 12 months. This model would appear to support the views of Powell and Mester.
The burden of proof, however, is on the critics and disbelievers for the YCS has demonstrated efficacy across a variety of economic environments and monetary policy regimes (i.e., pre- and post-Bretton Woods Agreement on fixed-exchange rates).
Do keep in mind the YCS is not a coincident indicator, but a forward-looking one. As it stands now, a flattening, but still positive YCS, indicates market expectations of a slowing economy in late 2018 / early 2019.
Perhaps things will be different this time. One should not rely on any one indicator but rather look at a wide variety of market-based signals coupled with certain statistical data (such as industrial production, purchasing managers indexes, and measures of business capital investment). Much of this data does suggest the U.S. economy continues to expand at a modest pace.
As for stock prices, as long as the economy is growing and the yield curve doesn’t invert, it is reasonable to expect further gains ahead. We believe with current valuations and the slope of the yield curve, it is wise to expect equity markets to deliver more modest gains than what investors have enjoyed in recent years as well as a higher level of volatility than that experienced throughout much of 2016 - 2017.
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