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Market Update - Inverted Yield Curve & China Trade War Thumbnail

Market Update - Inverted Yield Curve & China Trade War

After a pretty quiet summer, volatility has once again made its way back into the market. Stock market volatility as measured by the VIX (the CBOE Volatility Index) has moved from the low 12’s in early July to a high over 24 in August. There are two main factors that most market participants are looking at: the U.S. Treasury yield curve inversion and the U.S. trade war with China.

The Inverted Yield Curve

As you can see from the chart (the green line crossing the zero line), the yield on the 10-year Treasury note is now less than the 3 month T-Bill. Why is this a big deal? A yield curve inversion has historically been a powerful predictor of an economic recession. In the past 50 years, the yield curve has inverted prior to every recession and has only given a false signal once in that time frame. Following a yield curve inversion, a recession usually comes within the next 12-24 months. The U.S. Federal Reserve and other Global Central Banks are not just standing by and have already started to ease monetary policy and lower short-term interest rates to combat the inversion. Over the next few months, the economic data and corporate earnings will give us some clues as to whether or not monetary policy can reverse what may already be inevitable.

The Trade War

Politics aside, there are two main issues for the trade war between the United States and China. First is the U.S./China trade deficit. Currently, between the U.S. and China, we import approximately $539 billion of goods and only export around $120 billion. This leaves the U.S. with a trade deficit of approximately $419 billion. Second, the U.S. accuses China of intellectual property theft and lack of enforcement on existing intellectual property laws. Many of the accusations come from something called “Forced Transfer Agreements”. When a company wants to enter the Chinese market, the Chinese Government forces the company to share its technology with Chinese companies. The U.S. contends that these transfers and China’s lack of intellectual property protection law enforcement cost the U.S. as much as $600 billion per year.

How is This Impacting The U.S. Economy?

As the two largest economies in the world, the trade war is now having a global impact on growth and most economists believe this will continue until there is a resolution. According to the International Monetary Fund (IMF), the world growth rate for GDP was 3.8% in 2017, 3.6% in 2018, and the projection for 2019 is 3.3%. Although those numbers are positive, economists, and more importantly the markets, are more concerned with the trend of the numbers. 

So far, the main weapon of the trade war is tariffs. The trade war has now been going on for more than a year and there is still no end in sight. Due to the length of time and the escalation of the tariffs, if you are a company of any size that imports anything that is impacted by these tariffs, you are forced to consider alternatives.  This in turn changes the behavior and psychology of business leaders and will have an impact on their spending and investing and will weigh on near-term growth.  In our opinion, this has been the biggest reason for the recent volatility (that and some untimely tweets). Global declining growth rates are the primary reason for the yield curve inversion.

Where Do We Go From Here?

In light of all of the recent events, as we have said in our previous market updates, this has been the longest bull market in history and we are most likely in the later innings. No matter the reasons or the causes, recessions and bear markets are normal parts of economic cycles and both will be coming sooner or later. Rather than trying to predict when a recession will start or the next bear market will come, the right thing to do would be to assess your current situation as if a recession or bear market were to start tomorrow. If you constantly view your investments this way, not just when volatility is high, it will save you from potentially poor decisions when your portfolio is down and your emotions have taken over. 

Some things to consider are:

  • Do I have an emergency cash reserve?  If not, do I have liquidity? Could I raise money quickly and efficiently from my portfolio if I need to?
  • Is my portfolio too risky for me and/or my goals?
  • Am I over weighted in any stock, sector, or investment that could negatively impact my portfolio?
  • What is my overall allocation?

If you have any questions or comments, let us know.