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Market Strategy 8/19/2019

  • John Stoltzfus
  • August 19, 2019

You Can’t Always Get What You Want

Recession fears rose last week as a key segment of the yield curve briefly inverted

Key Takeaways

  • The week ahead will see investors focus on the Fed, with the release of the July FOMC meeting minutes and Fed Chair Powell’s opening address at the annual Jackson Hole symposium.
  • Last week’s dramatic volatility sparked by a brief inversion of the 2/10-year Treasury yield curve and with Friday’s equity market rebound will be a prelude to this week’s action as investors ponder the direction of markets ahead.
  • We consider differentiating factors between what led to the financial crisis in 2007-08 and conditions today.
  • Economic data released last week showed sustainability in the economic expansion.

Keeping things in context brings us to the conclusion that the sell-off in equities and the surge in bond prices over the last week—and for most of August so far – has been overdone. “Waaaaaay” overdone.

By last Friday, it looked as if the market was beginning to get that same idea. Time will tell as markets navigate the week at hand.

stock chart

From our perch on the Market Radar Screen, it seemed to us that what started with some selling on disappointment with progress on trade talks and the markets’ perennial mistrust of the Federal Reserve had led to relative extremes in volatility in the stock market and a surge in bond prices.

These events showed at least some signs that negative projections about the strength of the US economy had once again gotten far off the proverbial beam
(ignoring positive economic data that might offset concerns). Indeed, these negative projections had gotten away from the reality that even as dysfunctional and uncertain as things may be, they are not anything as bad as some of the headlines, pundit commentaries, and Street-side projections would have you believe. Comparisons to 2007 and 2008 that we’ve heard some proffer, in our view, miss decidedly different structural factors between then and now tied to levels of interest rates as well as economic and corporate fundamentals.

If anything, it would appear to us that what we have been passing through in August mimics in a distorted mirror what markets went through in the fourth quarter of last year—though thus far with not quite as sour an effect on the equity markets.

Quotation from Aenean Pretium

Still the bond market and to large extent the equity market persist in mistrusting the Fed’s judgment.

The sell-off in the fourth quarter for those who recall it was built on negative projections about a dramatic drop in the price of oil (Oct. 3- Dec. 31), worries that seemed to reflect the thought that the Federal Reserve Board was hell-bent on raising rates so high and so fast that it would push the US economy into a recession as well as by fears that the US and China would never find some common ground upon which to tether a kind of resolution to get out of the trade war.

In the third quarter of this year, we find some corners of the market fearful that the Fed remains “behind the curve” (keeping rates too high). This view persists, even though the authorities just delivered what we’d call a “compromise” rate cut of 25bps in July and seem poised to do so in September if needed.

Sluggish economic data that parallels previous periods of slowing in the current expansion that began in 2009 is being interpreted by some as pointing to a recession. Meanwhile, opinions persist projecting negatively on the potential for a trade agreement with China even as talks continue. Negotiations at the level of global trade between the US and China are not a stroll in the park but are more likely a contentious, cliff-hanging, drama-laden processes.

The positive offsets to the negatives remain visible in economic data and in the current earnings season that crossed the transom last week (see pp. 4 and 5 in this report).
As the world turned and some stomachs churned, economic data stateside continued to signal sustainability of the current economic expansion even if not at a robust pace. Inflation remains in check even as some green shoots of “reflation” glow positively in consumer, housing, employment and wage data.

We believe it is the good fortune of the US that at this juncture it is a consumer- and services-dependent nation for the bulk of its economic growth—with manufacturing accounting for only around 11 to 12% of GDP. (Perhaps in a post-trade war resolution world, the US economy ironically could become more dependent on manufacturing, but for now that is not the case.)

That there is weakness in manufacturing should come as no surprise to anyone, considering the dependence of the global supply chain on Chinese inputs. We expect that China’s political leadership has already recognized an acceleration of a trend for companies around the world to diversify their supply chains away from what has become in a number of industries overdependence on China. That trend, which began as the costs of doing business in China rose over the years just prior to the trade war, is likely to continue and at an accelerated pace, should the trade war grow protracted. China’s goal of “Made in China 2025” could be indefinitely detoured should the trade war with its best customer run too much longer.

For the US, the election of 2020 is not that far off. Key administration agenda items that include drug pricing and infrastructure spending need time for thought, process, and focus that is challenged by the energy required to wage a trade war of magnitude.

The Bond Market

We remember all too well the inversion of the yield curve that was persistent in the period leading to the financial crisis of 2008. Last week’s inversion (as the 10-year Treasury yielded less than that of the 2-year note for brief periods intraday) as well as those experienced earlier this year and in 2018 appear to us to find their source in a distinctly different period along the timeline of the global economy and markets.

The yield curve inversion that flashed steadily in the period leading up to the crisis of 2008 reflected abusive practices in lending and borrowing, exacerbated by a Fed hike cycle that saw the benchmark rate go from 1% to 5.25% in a two-year period (June 30, 2004–June 30, 2006). Essentially, monetary policy in that period went from “super cheap money” to “rather expensive money” for borrowers (individuals, corporates and governments).

In the current cycle, the Fed raised just nine times in a three year period (December 2015-December 2018), taking the fed funds rate from a band of 0-0.25% to a band of 2.25%-2.5%, after which it cut its rate by 25 bps in July 2019. So far in this cycle, the Fed has moved in our view from “nearly free” money to “still cheap” money.

Fed policy last cycle showed significant misjudgment regarding strengths and vulnerabilities of the US economy. The results were near-devastating.

During this cycle, in our view the Fed has been extremely sensitive (through three different leaderships at the central bank) to both strengths and weaknesses in the economy.

Still, the bond market and to large extent the equity market persist in mistrusting the Fed’s judgment.

We acknowledge that the Fed could make a mistake after over a decade of “delivering the goods” to a recovery that has developed so far into a sustainable expansion supportive of a remarkably resilient equity and bond market, notwithstanding fluctuations that garner significant attention from time to time.

We do not believe that the current low level on yields in US treasuries reflects so much weakness in the economy or trouble ahead as much as the dollar’s role as a safe-haven currency in a time of trade tensions along with negative yields in many countries.

Bond buying programs by central banks around the world (particularly the ECB and Japan) have also created shortages of bonds in many markets as demand for yield rises.
We look for an up to 180-degree turn in economic and corporate projections, when a trade war resolution surfaces.

For now, patience and discipline are required of investors. We persist in favoring cyclical exposure in equities over defensive exposure in a period wherein defensive sectors appear somewhat overbought.

Avoidance of buying into the negative “projection du jour” could well pay off for investors as it has for much of the last ten years as monetary policy has remained sensitive to economic weaknesses and strengths.

Meanwhile, globalization and technology drive the underlying growth that creates opportunity even as it presents risks.

John Stoltzfus of Oppenheimer Asset Managment Inc.

John Stoltzfus


Chief Investment Strategist, Oppenheimer Asset Management Inc.

John is one of the most popular faces around Oppenheimer: our clients have come to rely on his market recaps for timely analysis and a confident viewpoint on the road forward. He frequently lends his expertise to CNBC, Bloomberg, Fox Business, and other notable networks.

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