Something Wicked This Way Comes...

08.08.2019 - Jeffrey S. MacDonald, CFA

The three witches in Shakespeare’s Macbeth seem to spend a decent chunk of their days making predictions about things. Probably the most famous and quotable of these is the tingling feeling witch #2 gets in her hands suggesting something evil is on the way. This “pricking of my thumbs” proves to be pretty reliable as Macbeth (not the nicest guy you’re likely to run into) shows up knocking on the witches’ door soon after.

The global bond market has also earned a reputation (rightly so) for coming up with forecasts of future events of the economic sort. While one can debate the historical accuracy of these projections, there is no doubt the global bond market is signaling the outlook for the global economy is evolving quickly, and not for the better.

Markets so far this year were buoyed by the hope that several challenges--including tight monetary policy, strained trade relations and a slowdown in economic growth globally—would stabilize and improve. Investors were encouraged by a more dovish pivot from the US Federal Reserve, positive news flow on US/China trade negotiations and China stimulus having global implications for improved economic growth.

While the optimism ebbed and flowed, the general consensus coalesced around an extension of the current economic expansion, albeit at a more moderate pace…until now.

Why Is the Market Reacting Now? 

At the G20 meeting in June, the US and China agreed to a “trade truce” and promised no new additional tariffs while discussions around a deal were re-opened. The first of these meetings took place in Beijing on July 31, attended by Treasury Secretary Mnuchin and Trade Representative Lighthizer.  While a deal at this meeting was never on the table, initial indications were that the conversations were constructive and suggested that the lines of communication would remain open. 

The following day President Trump, in a surprise move, initiated another phase of tariffs on the balance of Chinese exports to the US, amounting to a 10% tariff on $300 billion of goods per year, with the suggestion that he could move the level to 25% in the future. This round of tariffs is slated to kick in on September 1 and has a healthy dose of consumer goods on the list.

China responded quickly, canceling all agricultural imports from the US and, more importantly for financial markets, allowing the yuan to depreciate 2% on Monday of this week, breaching the level of 7 yuan to the US dollar, a level they have actively defended since the financial crisis.  The US struck back, officially labeling China a currency manipulator, with accusations of weakening the yuan selfishly at the expense of global trading partners. 

At the same time, global macroeconomic data has continued to deteriorate, with manufacturing continuing to contract and growing evidence that the current environment is negatively impacting sentiment, business confidence and investment spending.

The Bond Market Is Feeling a 'Pricking of its Thumbs'

If the bond market was holding out hopes that the US/China trade war would stabilize and inject some confidence in the global economy, the past few days likely put an end to that hope.

The US Federal Reserve seems unwilling to commit to the notion that July’s rate cut was the beginning of a prolonged easing cycle, but other global central banks aren’t waiting around.  On Wednesday alone, three Asian central banks (India, New Zealand, and Thailand) announced surprise rate cuts in excess of 25 basis points. In publicly traded markets, global yields continue to make historical lows.  In Germany, 10-year bunds are trading around negative 60 basis points representing an all-time low. The entire yield curve in Germany, the benchmark for eurozone rates, is now trading at negative yields. 

Since these announcements, the amount of negative-yielding debt across the globe surged and is approaching $15 trillion. Here in the US, 10-year Treasuries have pushed ever closer to the sub 1.50% level that was reached in 2016, with the rally in bond prices reducing 10-year yields 30 basis points in August alone.  Credit spreads, led by high yield bonds, have widened meaningfully with the deteriorating outlook as risk is being repriced across markets. 

Yield curve inversions occur when the interest rate on long-term bonds is lower than the rate on short-term bonds. Currently, T-bill yields are exceeding those of 10-year Treasuries. Perhaps most important to the outlook, the inversion of 10-year Treasury and 3-month T-bill yields increased by 30 basis points to the highest level we have seen since the great recession. These inversions have been very reliable indicators of coming recessions in the US over time.  The reliability of these signals increases with the duration and magnitude of the inversion so with the persistence of this condition continuing since mid-May and increasing in recent days this warning sign seems to be gaining in credibility.

Our View

We believe a recession does not appear to be directly in front of us. However, it has become difficult to make the case that economic growth is positioned to accelerate under current conditions. If the global economy manages to avoid recession in coming quarters, the incoming data suggest that it will likely be by a very slim margin. Regardless of whether the world is headed into a technical recession, the recent bond market activity certainly suggests fixed income investors are currently feeling a “pricking of their thumbs.” 

This communication is intended solely to provide general information. The information and opinions stated are as of August 8, 2019, and may change without notice. The information and opinions do not represent a complete analysis of every material fact. Statements of fact have been obtained from sources deemed reliable, but no representation is made as to their completeness or accuracy. The opinions expressed are not intended as individual investment, tax or estate planning advice or as a recommendation of any particular security, strategy or investment product. Please consult your personal advisor to determine whether this information may be appropriate for you. This information is provided solely for insight into our general management philosophy and process. Historical performance does not guarantee future results and results may differ over future time periods.

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