Fear Itself?

As 2018 fades to black, we find ourselves in more volatile markets than we have seen in a while. Multiple large daily drops, at times followed by enormous upswings like the 5% surge on December 26th, are par for the course. Almost all asset markets are negative in the year to date, even former stalwarts of positive return like US stocks and high yield bonds. No developed country stock market is up for the year. Emerging markets, whose outcomes are more varied, are also in the red thus far, though change may be in the air; seven have been rallying for the last three months. Treasury bonds are now positive in reaction to the equity selloff. Short and intermediate corporate bonds have also eked out small gains.

Markets are nervous. Are problems coming down the pike or, as FDR would have put it, do we have nothing to fear but fear itself? No one can say in the moment what is driving the volatility and the selloffs. History will judge. What we can say is that the stock and bond markets are sending us signals, signals about participants’ beliefs regarding economic and political developments. These signals are hard to read, cloaked in noise as they are. We don’t yet know the answer, but we do know that concerns can be overblown and that overreacting to volatility can be counterproductive.

Below are some issues we have seen raised in the press or by market participants. It is not a comprehensive list, nor does it imply a clear direction. Don’t read too much into it; it is far easier to enumerate a list of fears than to see the opportunities. Those will come in time. In the meanwhile, don’t let volatility drive you off course.

  • Fed tightening: The US central bank has raised the funds rate upper bound to 2.5% from just 0.25% in December 2015. It has also been shrinking its balance sheet by letting treasury notes and mortgages it holds mature rather than reinvesting all the proceeds.
  • Yield curve inversion: Some short term bond yields rose above longer term yields earlier in December causing a yield curve inversion.  Yield curve inversions have often preceded recessions, though it has taken as long as two years from the initial inversion for the recession to arrive.
  • US tax cuts boosted earnings for many firms in 2018. In 2019, there will be no such boost. Tax rates will still be low, but the comparison will be apples to apples. Earnings growth will have to come from business growth, not outside forces.
  • Leverage in the US corporate sector is very high, as it is in the rest of the world. There may not be a systemic risk from this debt pile, as there was ten years ago, but higher rates and slower growth could strain many companies.
  • China’s growth is decelerating. The easy gains from urbanization and industrialization are petering out and the trade war may be taking its toll. Debt issuance has been high for the last decade, much of it for uneconomic projects. If the government takes on the distressed debt, it will diminish its capacity to stimulate the economy. Chinese equity markets have been among the worst performers this year. Will China follow Japan into stagnation or is there a productive way to reignite growth?

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