The month of August started with the stock market falling hard, the bond market rising fast, and increased volatility everywhere. These three things have a history of happening at the same time, so it’s not unusual. Volatility typically increases when stocks fall, and the money that leaves stocks usually moves into safer assets like bonds. Here is a quick brief on recent market events that help explain some of the volatility:
- On August 1st, President Trump escalated trade tensions with China by increasing tariffs on Chinese imports.
- On August 4th, China retaliated by devaluing its currency, a fundamental maneuver that aims to benefit China and hurt the US.
- On August 14th, a widely followed bond yield curve inverted, a phenomenon that has been a historically accurate forecaster of slower economic growth ahead.
The trade war is nothing new, the yield curve is
The first two points are policy-related, meaning each government is in direct control of the actions. Neither policy is market-friendly and they are a continuation of the Trade War between the US and China. The third point is a market force, meaning it occurred naturally in the capital markets. While one can argue why the bond yield curve inverted, there’s really no way to know the exact reason. The bottom line is that the Trade War and the yield curve inversion in the bond market are the main factors driving market volatility right now.
The Trade War has been a storyline in the market for more than a year. Every time it comes into the spotlight, volatility increases. However, the circumstances surrounding the Trade War are more predictable than the circumstances surrounding the yield curve inversion. For instance, we can assume that President Trump wants to win re-election in 2020. Two things that would likely help his cause are a stable stock market and a steady economy. Therefore, it likely isn’t in Trump’s best interest to escalate tensions with China much further. Doing so risks self-inflicted wounds to the economy that could hurt his re-election campaign.
What the market is struggling with
Why then is the stock market reacting so precipitously to Trump’s recent actions and China’s response? We think the market is struggling with two things as it relates to the US/China trade war:
- What are the economic implications right now? That is if things stay the same between the two nations, how bad is this new status quo.
- What if the trade war escalates even further?
The second question is the one that is likely causing more Trade War anxiety. Markets adjust to new information very quickly. The concern with #2 is that the market doesn’t have all of the information. While we can argue it’s not in the President’s best interest to escalate things with China, we also admit that he’s a hard President to figure out. Assuming we know his next move is a dangerous game, and the market has to account for the unpredictability of his future actions.
Predicting the market’s response is a guessing game
In other words, the market doesn’t know if the trade war will escalate, but that doesn’t stop it from falling to reflect negative possibilities that are not yet known. The market’s way of thinking in times like these is what is the next shoe to drop? This line of thinking has contributed to the extreme volatility of the last few weeks. This is not unusual. Markets almost always fall faster than they rise. This is because investors generally panic all at once, but then regain their confidence in the market at varying rates.
An analogy we can use is a group of friends who have a bad experience at a restaurant. One of the friends is usually willing to give the restaurant another chance, while another may swear to never go back. Recoveries in markets tend to work the same way; some participants are willing to start taking risks again quicker than others.
But what about that yield curve inversion?
In relation to the yield curve inversion in the bond market, things are a bit murkier. Yield curve inversions are the bond market’s way of saying, “Hey, the economy is going to start slowing, and maybe even enter a recession!” This is a cause for concern, but it’s likely no reason to panic. The simple take away is this: after a 10-year economic expansion, the bond market sees elevated risks to the economy. However, this doesn’t necessarily translate to lower stock prices.
Since 1978, the S&P500 has averaged a gain of 12% one year after similar yield curve inversions, according to Credit Suisse. In addition, it’s taken an average of 22 months before a recession actually begins following this type of yield curve inversion. Of course, averages do not tell us the whole story, but they can help us form some of the basis for our decision-making moving forward.
Here’s what we expect
We certainly do not expect the stock market to collapse, nor do we forecast a dire recession like what occurred in 2008. However, we do acknowledge that the next five years of stock market returns probably won’t be as strong as the last five years. But that’s not an opinion we’ve formulated only in response to recent market developments. In reality, the S&P500 is at the same price as it was one year ago. That means our expectations for stock market gains have already been muted.
Ultimately, what’s happening in the market right now likely means different things to different investors. Not everyone wants to take the chance that the market doesn’t fall meaningfully within 1-2 years. However, we would caution against putting your personal feelings about the market above your personal investment timeline. We can think the market will do one thing but it can just as easily do another.
Here’s what it means for you
Here are a few general examples of how your investment time horizon is more important than market cycles in the current market environment:
- Someone nearing retirement should not have aggressive stock market exposure for risk of if the stock market does drop 15-30% within a few years.
- Someone in retirement should already have modest, if not aggressive exposure to bonds and is benefitting from the rise in bonds prices in 2019
- Someone who has used the market to reach a goal (such as buying a home) may want to consider moving those savings to safer assets, as to protect gains from the bull market of the last few years
- Someone between 10-20 years away from retirement should stress test their portfolio and consider if their own risk tolerance has changed since they first started investing
- Someone 20 years or more away from retirement is likely best off riding out whatever ups and downs may come their way in the coming years. If anything, this person should be prepared to invest more aggressively if there is a sustained downturn in the stock market.
In conclusion, the recent volatility in the market is being driven by two main themes: the US/China Trade War and the yield curve inversion in the bond market. We expect this volatility to persist for the foreseeable future. We also think risks have risen to the economy, and thus the potential for future stock market returns are lower than in years passed. However, it is impossible to predict what the stock market will do. Our best advice is that investors frame the current market in the context of their own investment time horizon, not in terms of what they think the market will do next.
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