4th Quarter Market Commentary

“The pessimist complains about the wind; the optimist expects it to change; the realist adjusts the sails.” (William Arthur Ward)

Instead of sailing into a calm and relaxing end to summer, the past few months have brought winds of volatility to the markets and increased risks for the global economy. The treasury yield curve (10 year versus 2-year yields) inverted in August, U.S. and China grappled with tariff’s, Brexit outcomes are uncertain, civil unrest in Hong Kong sank tourism trends and a general slowing of the economy in the Eurozone are just some of the imbalances we see around the world. Some of these ongoing uncertainties (and new ones we haven’t even yet recognized) will almost certainly continue to bring volatility to the investment markets and weigh on economic prospects for growth as we end 2019 and head into 2020.

The most recent – and perhaps the most important – concern for the investment markets has been the inversion of the 10-year/2-year Treasury yield curve. The yield curve “inverted” which simply means for a period of time, the 10-year Treasury yielded less than the 2-year Treasury – which is not the usual circumstance. This is important because it has preceded every recession in the last 40 years.

Recessions are inevitable and occur at the end of every economic cycle, so the U.S. economy is destined to have one, eventually. The unknown factor is the amount of time until it arrives. While the inversion of the Treasury curve has historically been a reliable predictor of recession, its use as a timing mechanism leaves a lot to be desired. The lag time between an inversion and the start of a recession has varied between 7 months and 2 to 3 years – with the average lead time of 14 months.

Recessions, though necessary (and some would argue beneficial), part of the business cycle, can be like sailing through stormy seas for the broad economy and the equity market. Going back to the early 1950’s the equity markets have witnessed returns ranging from -35% to +18% during the recessionary period, and if you go back far enough to include the Great Depression the range of returns widens all the way from -76% to +29%.

It is my opinion, the odds of a recession appearing during the final few months of 2019 are remote, primarily because the biggest driver of U.S. economic growth – consumer spending – is still chugging along. At 60%+ of total GDP, the U.S. consumer is a vital component of economic growth and, up to this point, consumer confidence has remained solid on the backs of access to easy and cheap credit, positive wage growth and a tight labor market.

With the domestic manufacturing sector weak and most of the Eurozone mired in recession, the U.S. consumer looks to be the last bastion of hope to keep the U.S. economy growing. Tightening of credit standards, a future uptick in unemployment, or a decline in wage growth that causes weakness in consumer confidence would be a strong confirmation of the impending recession predicted by the Treasury curve inversion.

Now, let me point out two “outliers” that could possibly cause sharply increased volatility in the equity markets in 2020: a blowup in the credit markets due to excessive debt levels and uncertainty around the political landscape.

On a longer-term basis, without question the biggest potential problem impacting future global economic growth is the sheer massive amount of debt that has built up during the past decade of artificially low interest rates. Debt in and of itself isn’t always bad, and may even be good if used for productive purposes. The problem today is the vast majority of the debt outstanding hasn’t been used in a constructive manner.

Individuals have used access to low rate debt as a way to finance spending above the level their incomes will allow. Companies have floated literally trillions of dollars of debt to buy back their own stock at lofty valuations, finance poorly managed business operations or make questionable and costly acquisitions. Governments have issued bushels of debt to avoid even the appearance of trying to balance their budgets and finance social programs they know are unaffordable otherwise.

As can be clearly seen by the precedent set in Japan and Europe, excessive government debt accelerations depress business conditions, which reduce economic growth, and leads to even lower rates. When real yields are low (or even negative) investors and entrepreneurs will not earn returns commensurate with the risk. Decreased capital returns will prolong poor economic growth, and the government lowers rates even more in an effort to try and spur increased economic activity. The cycle continues over and over.

There are now about $17 trillion worth of negative yielding bonds outstanding, mostly in the sovereign space. That’s about 25% of the entire global bond market, and 43% of all the bonds in force outside the U.S. This has never before happened in history, so there is no precedent upon which to draw conclusions about how it will end – but I am confident in predicting it won’t be good.

Think of it – the German government can issue 30-year bonds with a -0.22% interest rate. In fact, as of this writing, the entire yield curve for German bonds is negative! The European countries can’t afford to continue funding their massive social programs without saddling their citizens with huge tax increases.

That is a distasteful reality which would bring unwanted social unrest and more than likely major political upheaval, so the European Central Bank (their Fed) has brought down their borrowing cost to less than zero by creating (as Bloomberg calls it) “pixie dust” money and buying the bonds issued by individual Eurozone governments. Now they can continue to fund bloated government programs at literally zero cost. The term “land of the free” means something totally different in Europe!

And it’s not just governments that can borrow at negative yields. Siemens AG, a German company, recently issued $3.9 billion worth of bonds at an average yield of -0.3% and there were more buyers than bonds available! And some Danish banks are now offering home mortgages at a -0.5% rate!! When you read the “fine print” on the loans, the underwriting fees cost the borrowers a little more than the -0.5%, but they are still able to buy that new home at essentially a zero-mortgage rate.

In my opinion, this pattern of ever declining rates globally will force the U.S. Federal Reserve to continue to lower domestic rates, and we may even see our rates close to zero by the end of this cycle. That will be negative for savers and the most conservative investors who are averse to putting their hard-earned money into anything other than traditional income choices. It will force many other investors to increase the risk in their “income” investments by adding to their equity allocation, expanding into lower quality income offerings, or even delving into “alternative” investment strategies in their reach for higher yield.

The real danger in this global race to the bottom in rates is that the buyers of this unrealistically priced paper begin to demand higher returns for the increased levels of risk. Higher rates would be a serious negative (and could be a death knell) for governments and companies addicted to a world where money has a zero cost and there is no penalty for poor management of resources. That would lead to massive failures and loss of capital for investors. Most likely, this will not be the case in the next year, but is a possible “black swan” outcome in the future.

The second outlier that could drive increased volatility in the equity markets in 2020 is the looming Presidential campaign. This not a political statement – my interest in the conduct of the campaign and the eventual outcome is related to the impact it could have on the investment landscape and the potential for increased volatility. From that perspective, my opinion is the best we can hope for is continued gridlock. Based solely on current campaign platforms, a Democratic Congress and White House would likely mean increased taxes and possibly the implementation of some form of Modern Monetary Theory (MMT – Google it for a more detailed understanding). A Trump re-election would likely mean four more years of volatility driven by random tweets. Choose your poison wisely.

The possible silver lining for equity investors is that the response by the Fed to any increased turmoil, or sharp deceleration in economic activity is surely to be either rate cuts, or the reinstatement of Quantitative Easing (asset purchases by the Fed) or both. Neither will likely fix the underlying problems in the longer term, but could be effective at inflating the asset bubble (equity market) to new all-time highs in the short term.

The trick for individual investors will be to properly allocate to benefit from any potential inflation of equity market valuation levels caused by the Fed’s meddling, but to also try and sidestep the majority of any temporary (or permanent) loss of capital from any resultant significant decline. As Warren Buffett famously says, “No one rings a bell at the top of the market”. It is impossible to time the market, and most investors are smart enough to understand this reality. However, it is prudent to understand the risks and be prepared for the possibility of more bouts of volatility.

Our suggestion, and the way in which we are approaching the management of our client portfolios in light of the foregoing discussion, is to keep a diversified portfolio with an appropriate amount of equity exposure relative to each client’s individual risk tolerance and time horizon. Within the equity allocation, we currently favor U.S. equities over international, large caps over small caps, and with an overall weighting toward more defensive sectors.

On the income side of the allocation, we continue to favor high quality individual bond issues, primarily with an intermediate term where we can still reap the benefit of some positive yield while realizing potential price appreciation if rates continue to decline. We will also add limited exposure to specialized income instruments (like preferred issues or Real Estate Investment Trusts) to enhance yield where appropriate.

Though we may find ourselves sailing through choppy seas as all these variables in the investment, economic and political arenas are resolved over time, if we are attentive to the direction of the wind, pay attention to the expected forecast and keep our ship in sound working order, we can navigate our way through to the calm waters beyond the storm.

Achieving this objective however requires each individual investor to be diligent in their efforts to develop a sound financial plan, implement a solid investment strategy and regularly rebalance their portfolio to ensure it remains in line with their overall goals. As always, we encourage current clients of YHB Wealth to reach out to us with any questions and consistently work with us to ensure their financial plan is up to date. We also welcome inquiries from clients of YHB CPA that may want to discuss their specific financial situation with us personally.