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Thoughts on recent market volatility

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Wednesday, August 1, 2018

Fears of impending recession took hold of market participants Wednesday as a key barometer of the health of the economy, the U.S. Treasury yield curve, inverted at a closely watched segment of the curve with the 10-year yield briefly falling below the yield on the 2-year note. Although the 10-year yield quickly recovered ground to rise back above the 2-year, the damage was already done as programmed trading took the inversion as a sell signal and other investors followed suit, fleeing risky assets like equities in favor of safe havens like U.S. Treasury bonds, further exacerbating the falling bond yields. As a result, U.S. equities broadly posted one of the worst days of the year, with major stock indexes including the Dow Jones, S&P 500, and the Nasdaq Composite all losing about 3% on the day. Given the warning shot from the Treasury yield curve and recent market volatility from geopolitical tensions, we wanted to provide you with major takeaways from our portfolio management team on the recent market moves and our fundamental outlook.

Historically, an inversion in the yield curve has preceded all economic recessions in the U.S., as it indicates that investors expect that the Federal Reserve may need to slash interest rates to stimulate the economy in response to a declining outlook for growth and inflation. Although such an indicator should not be taken lightly, we would note that not all historical yield curve inversions have been followed by recessions. And in some cases where it has preceded recessions, the lag between inversion and recession has been up to 2 years, which we wouldn’t really classify as “impending”. Therefore, we must look at the underlying fundamentals of the economy to truly gauge whether or not this signal is telling us of near-term recession or perhaps a slowdown to more moderate, but still positive, rates of economic growth. We are currently more inclined to believe the latter.

One of the most significant factors informing our perception of slowing economic growth rather than impending recession is the fact that the U.S. economy, the largest on the planet, is driven primarily by the U.S. consumer from which about 70% of our GDP growth is derived. Therefore, the health of the American consumer should be a key focus, and the story remains positive here. Our unemployment rate is near 46-year lows, and the average worker is getting a 3.2% annual increase in wages, which is in excess of inflation and is not causing a concomitant rise in inflation that would erode purchasing power. On top of this, consumer confidence is near all-time highs. We don’t see the strong employment situation changing near-term, either, as a tight labor market will make employers less inclined to release employees if we hit a rough patch. This is not to say that the U.S. is immune to slowing international growth and trade disputes; these factors certainly are and likely will continue to weigh on U.S. economic growth, but we believe the continued strength of the domestic consumer can offset much of this weakness. 

Let’s put recent stock market volatility in perspective, as well. Despite the recent bout of volatility, the S&P 500 is still up 13.3% year-to-date (14.8% including dividends). Additionally, we have a very recent example of the importance of staying invested through periods of volatility as U.S. equities dropped almost 20% at the end of 2018, just to come roaring back in 2019 to more than offset losses, broadly speaking. Investors reacting to the volatility of the market rather than the underlying economic fundamentals could have missed out on an 8.0% return for the S&P 500 in January alone of this year if they sold out in December amid the sell-off.

Overall, we currently believe in sticking with the risk positions across our client portfolios, but we will continue to monitor the strength of the U.S. consumer closely, in addition to global economic and geopolitical developments, and we won’t hesitate to act on reducing risk exposure on behalf of our clients if the fundamental outlook deteriorates. As always we welcome your comments and are always available for consultation if you have more questions.

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Investment Management solutions provided by First Merchants Private Wealth Advisors may not be FDIC insured, are not deposits of First Merchants Bank, and may lose value. Investments are not guaranteed by First Merchants Bank and are not insured by any government agency.  This material has been prepared solely for informational purposes. First Merchants shall not be liable for any errors or delays in the data or information, or for any actions taken in reliance thereon. Any views or opinions in this message are solely those of the author and do not necessarily represent those of the organization.