What a difference a few days make. Last week the Dow Jones Industrial Average had hit a new high and was rapidly approaching 27,000. Today it plunged 832 points, the 3rd largest point drop in history. The S&P 500 had climbed over 9% year-to-date. Today, it skidded 3.2%. The once high-flying tech stocks, which had been leading the market higher, are suddenly in a tailspin. The NASDAQ declined 4% today, its worst day since Brexit. Amazon, the darling of Wall Street, plummeted 6%. What’s going on? Why have investors suddenly become so skittish?
Recent strong economic data, especially last week’s jobs report, caused a sharp sell-off in the bond market and a corresponding jump in interest rates. The yield on the 10-year U.S. Treasury note spiked from 3.06% to 3.23% in just two days last week. It has since backed off slightly, but it’s had a big move since the beginning of the year where it stood at 2.41%. The stronger than expected data is causing investors to suddenly re-evaluate the direction of the economy. They’re recalibrating expectations for growth, inflation and interest rates. And yet, it’s not entirely clear which direction things are headed. With unemployment at a 49-year low and wage growth finally picking up, is the economy growing faster than expected, in which case interest rates are too low, and thus the Fed will need to raise rates more aggressively than anticipated to quell runaway inflation? Or, is the recent economic strength a sign that the economy is peaking and about to slow, as the tax cuts wear off and the tariffs take hold – and the trade war disrupts global supply chains - and thus the Fed’s rate hike policy is already too aggressive, and likely to overshoot, causing the economy to eventually tip into recession? After all, Fed Chairman Jerome Powell said last week that the Fed might go beyond neutral, which sounds a lot like overshooting.
When you come to a fork in the road, take it.
- Yogi Berra
Investors are at a crossroads. They’ve come to a proverbial fork in the road. And both paths look decidedly negative. Is growth accelerating or moderating? Is inflation on the verge of spiraling out of control or in check? Are interest rates too low and likely to continue to spike aggressively or is the Fed already on a path of overshooting? When faced with this kind of uncertainty, it’s no wonder the market has become volatile suddenly.
We would suggest that the two scenarios outlined above are not the only two. There is a third path to consider which we think is the most likely path. The third scenario looks like this: Growth has accelerated lately because of the tax cuts, but that acceleration is likely to fade as the effect of the tax cuts wears off over time. Inflation is rising (and wage growth is picking up), but modestly. This is a sign of a healthy economy, an economy that has recovered. A little inflation is a good thing. The Fed is raising interest rates, but gradually, which will help keep inflation under control. It’s also reducing its $4.5 trillion balance sheet, but gradually, telegraphing every step along the way. In short, growth goes from good to great to just plain good again. The point here is that good is good. To use an overused phrase, which has become a bit of cliché by now, we might call this third path the Goldilocks scenario: Not too hot, not too cold. The other paths are certainly possible, but we think less likely. Rest assured that we will be carefully monitoring things – remaining ever vigilant – to see if one of the other two scenarios does, in fact, unfold, and we will act accordingly.
If the third path proves to be correct, and investors realize that the economy is not accelerating to the point of triggering runaway inflation, nor peaking and thus the Fed’s policy is too aggressive, thereby likely to tip the economy into recession, we expect markets to eventually calm down. With good economic growth – even if moderating from its current accelerated pace – and still good corporate profit growth – even if margins are pinched somewhat by goods inflation, wage growth, and the effects of the tariffs in the short term – the stock market can eventually continue its upward march over time. That’s not to say the sell-off might not continue as investors continue to recalibrate expectations in the face of uncertainty. It might. As we have pointed out many times, pullbacks and corrections are normal, even in bull markets. They can be unsettling, to be sure, but they’re normal.
But what about that trade war?
Besides the spike in interest rates, investors are also worried about the trade spat between the U.S. and China. As expectations for a quick resolution have faded, investors are worried that we could be in for a protracted trade war (a trade-related “Cold War”) between China and U.S. Here again, investors are recalibrating their expectations. While international markets and especially emerging markets have already declined due to the trade war, the U.S. market has held up…that is, until now. Investors are finally coming to the realization that the U.S. is not insulated from the trade dispute. The potential disruption of global supply chains, along with reduced demand and rising inflation, could spell trouble not just for foreign economies but the U.S. too.
These concerns are real and it’s certainly possible we could be in for a protracted trade war. But, we think that’s a low probability scenario. We think the trade war is temporary and will eventually get settled at the bargaining table. We cover this topic in greater detail in our soon-to-be-released third quarter commentary. As the trade issue gets resolved, international markets should recover, and the U.S. should snap back from any trade-related weakness. However, in the meantime, we could be in for some more volatility in the near term as the trade war continues to drag on.
The best line of defense
We have always held that the best line of defense against volatility is diversification and a valuation discipline (making sure you own assets that are cheap relative to their intrinsic value). We rely on both of these strategies to help protect our clients’ capital in volatile times. We have successfully weathered many storms like this before, utilizing these twin techniques, including the pullback that occurred in the beginning of this year. We think this period of volatility will also prove to be temporary.
Rest assured that we are monitoring all of these issues very carefully and will take whatever steps we think are appropriate to protect and preserve capital as conditions change.
Investors have come to a fork in the road and aren’t quite sure which path to take. We choose the path with solid economic growth, gradually rising but controlled inflation and interest rates, and a resolution to the trade war which supports a continuation of global growth.
As always, we appreciate your confidence in us. Please don’t hesitate to reach out to your wealth advisor for questions.