Comments on Recent Market Volatility (audio available)
Historically, August is a volatile month for the equity markets. Since 1990, on average the VIX Index sees its biggest monthly jump of the year in the month of August. Events such as China surprisingly devaluing their currency in August 2015 caused a 35% jump in the VIX Index or the downgrade of the U.S. credit rating in August 2011 caused an 80% jump in the VIX. This August, history has repeated itself with the VIX up over 40% for the month thus far. The factors driving volatility are countless. The rising risk of a hard Brexit, civil unrest in Hong Kong, another round of tariffs in the U.S./China trade war, slowing global growth and the misplaced fear that a temporary inversion of the yield curve means a recession is imminent. We want to address some of the catalysts of the recent volatility and comment on our current portfolio positioning.
Global economy is slowing and U.S. is following. Global economic growth has been slowing. Global manufacturing is in contraction territory. Germany is nearing a recession and China’s economy is slowing at the fastest pace since the Great Recession. While the U.S. has been relatively resilient to the global challenges, recent data is showing that our manufacturing sector is struggling. The ISM Index has fallen for four consecutive months to a three year low. Capex spending is falling and future expectations for spending have been trending lower. However, the U.S. consumer has been able to bear the burden of global uncertainty and is supporting the expansion
(consumer is ~70% of GDP). In fact, July core retail sales saw the biggest jump in four months. While the consumer should be supported by low rates, rising wages and a solid labor market we are not complacent about the recent weakness in data. While we do not expect a recession imminently because of the volatility this month we also know that recessions are inevitable and even healthy. We are monitoring forward-looking indicators (e.g. confidence and jobless claims) to see if the recent weakness is worsening but at this point, the consumer should support the expansion through this year, at least. In addition, from a historical perspective, politics may play a part in prolonging the expansion. Going back to 1928, there have only been three instances in the fourth year of a Presidential term (will be 2020) that the economy contracted for the year (i.e. 1932, 1980, 2008).
How worried should we be about the yield curve? There have been many headlines focusing on the temporary inversion (for less than one minute on 8/15) of the difference between the 10YR Treasury yield and the 2YR yield. While the 10YR yield and the Fed funds rate has been inverted for five months, the inversion of the 10YR and 2YR happened for the first time since 2007. The inversion was short-lived and has since widened into positive territory. History suggests that for an inversion of this portion of the yield curve to be a good recession indicator, the inversion needs to be persistent. In the past five recessions, the yield curve was inverted for, on average, 16 months
before a recession. Therefore, it is unwarranted to say that this temporary inversion has started the clock on the timing of the next recession.
Trade truce off the table..for now. Trade uncertainty is likely to keep volatility high. We will not speculate on politics, especially with the non-traditional way this administration relays news (e.g. twitter). Instead, we will focus on facts. Trade remains a small portion of our GDP so should not be the cause of a recession. Second, Trump needs a deal ahead of the election. Third, China is unlikely to withstand a prolonged deterioration in economic growth. Lastly, other emerging markets can benefit from companies moving business away from China.
Portfolio positioning: We are conservatively positioned from an asset allocation (overweight cash) and manager perspective (value-driven). However, at this time the risks for further downside remain (e.g. Sept. is a negative seasonal month for equities) and the recent pullback has not been pronounced enough to make valuations compelling to put cash to work in equities. The 10YR yield has seen a three standard deviation move and is near a three year low. While the $15 trillion of negative-yielding global debt could keep the rise in yields muted, we maintain a relatively intermediate duration in fixed income to mitigate the risk if the flight to safety in long term yields unwinds. We like international equities given favorable valuations and aggressive monetary policy but with ongoing risks, we are hesitant to add on recent weakness.
