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The Brave Report: Market Commentary for March 2019

Click here for the pdf version of this report: The Brave Report-March 2019

What inversion?… Some market uncertainties seem to be clarifying themselves as progress on the trade front continues and the Fed has basically said they don’t plan to raise rates this year.  However, something very unique and potentially worrisome has raised some flags with investors. The yield curve inverted as the rates on shorter duration Treasuries rose above rates on longer-dated ones.  This does not happen often and is seen by many as a sign that a recession is on the horizon.  Even with this new fear the markets continued to accelerate higher and capped off one of the best first quarters we have seen in years.

The questions still remain’ will history repeat itself and is this inversion really a leading indicator? Or are we in a much different environment this time around and we can continue to grow the economy even through the fear of a potential recession?

Market Overview

The markets finished off the first quarter on another high note, extending their gains from the previous two months.  The NASDAQ continued to outperform, gaining around 3% during the month, with the S&P 500 and the DOW trailing. The S&P 500 was up a little more than 1% and the DOW finished almost flat for March.  This continues to mark one of the best starts to a year we have seen in a long time and that normally bodes well for the remainder of the year. Investors continued their optimism around fed policy adjustments and the potential for a trade agreement with China.  The inversion of the yield curve, however, still worries some that fear a recession in the coming year.

The real movement over the last month was in the fixed income complex. We saw rates drop sharply throughout the month as almost all fixed income rallied.  The rate on the 10-year treasury dropped from a high of 2.75% on March 1st all the way to 2.35% in the last week of the month.   Not only did we see rates drop across the board we also saw some the yield curve invert as the gap between the 3-month treasury and 10-year went negative.  This is the first time we have seen this closely watched spread invert since just before the financial crisis in 2007. Historically, this type of inversion is seen as an indicator of an impending recession and will be very closely watched over the next few months.

Yield Curve Inversion: Back in November I discussed the prospects of an inverted yield curve and what that means for the markets.  I’m not going to rehash all of the points I made back then (feel free to look back at all of these reports are archived). In November we were starting to see some slight inversion on the short end of the yield curve.  This past month we saw the most watched, and worried about, spread invert as the yield on the 3-month treasury rose above the rate on the 10-year treasury. This was the first time this has happened since 2007 and we all remember what happened after that. For many, this is a leading indicator that a recession is on the horizon and historically that has been the case. However, this does not mean that a recession is a foregone conclusion or needs to become self-fulfilling.

So why might history not repeat itself this time:

  • The economy is still growing: While global growth has slowed and is expected to slow during 2019 that does not mean it will turn negative anytime soon. If growth picks up throughout the year, fears of recession will dissipate. Throw on top of this the potential for a trade deal with China and some of the factors weighing on growth will be eliminated.
  • The Fed can cut rates: It seems that the Fed may have overshot with their rate hikes or with the verbiage of their outlook. They have already softened their stance and some are now predicting the potential for rate cuts. Fed policy can have a major impact on the slope of the yield curve and can also help to stimulate growth that would avoid a recession.
  • Stimulus: I am not saying stimulus in the way we say after the financial crisis but any agreement on government spending such as an infrastructure deal would add to GDP growth and stimulate the economy away from recession.
  • Times have changed: While all recessions since 1970 have been proceeded by an inversion that was not the case prior to 1970. We are also in a much different rate environment than we have been during any other inversion.  Rates remain near historic lows across the yield curve so comparing the landscape today with that of 1981 when rates on the 1-year were around 17% is not an apples to apples comparison and makes it difficult to conclude that a recession is coming.

I am not trying to argue that there is no chance for a recession in the next few years but I am not predicting one any time soon. The characteristics of the markets are very different now than they have been in the past.  I think a lot of policy mistakes would need to be made to send us into a recession and even if that does happen it does not necessarily mean the stock market goes. Many people often confuse a recession with market declines. This is not always the case.  A recession refers to economic decline and not market decline.  One sometimes leads to the other but a market pullback does not mean recession.

Strategy Commentary

I slightly cut equity exposure this month as I rotated out of a few positions. I am still overweight equities but the fast start to the year has moved markets pretty quickly and taking a few profits seemed prudent.  It seems uncertainty around future rate hikes has been alleviated but questions still remain around trade with China and the inversion of the yield curve so I am comfortable just maintaining my current allocations.

Domestically I trimmed my exposure to healthcare.  I was a little late getting into it this fall and it has underperformed as the rest of the markets rallied during the first quarter.  I also reduced some exposure to industrials. I am still maintaining my exposure to consumer discretionary and technology as these higher momentum sectors continue to outperform as the markets rally.

I am still underweight European equities. They have performed great so far this year and I have missed out on some of those returns. However, the growth prospects still seem weak there and if there is a global slowdown, the risks there are higher then in other developed economies. I continue to be slightly overweight emerging markets and I think there is still some room to run if trade tensions can be eased. Although I am still bullish on China I am also starting to look to other emerging markets for some value.

My shift away from underweight in fixed income is looking like a good decision as rates have dropped over the past month.  With a little more certainty around fed policy for the rest of the year, I am still maintaining my neutral rating on the whole fixed income complex. With my exposure, I still have a bias toward the short end of the curve as the curve flattens or even inverts some more.