From a factor perspective, equity investors had nowhere to hide last month as the main equity style factors registered fairly even losses, all hovering between -8.5%, for Quality, to -9.8%, for Value. When volatility spikes and correlations approach 100%, effective diversification is not easy to achieve within an equity portfolio.
December: A Cold Shower of Negative News
Between President Trump’s “I am a Tariff Man” tweet, a U.S. government shutdown, the arrest of a Huawei senior executive in Canada, and a fumbling Brexit process, investors had ample worrisome material to deal with last month. However, the most negative driver was comments from U.S. Federal Reserve (Fed) Chair Powell, who spooked markets by saying that the balancesheet runoff program was on autopilot while delivering the ninth rate hike since 2015. His rosy economic assessment even had market commentators suggesting he sounded like Bernanke’s “contained” moment in 2007. Investor’s fear of a Fed policy mistake rose. Even the dovish remarks that followed from New York Fed President Williams were not enough to cheer investors. Although Williams sought to deliver a more pragmatic message, suggesting the Fed was not a preset course, he doubledowned on the autopilot remarks. What a month.
Is a Recession Near?
We have been expecting a slowdown for 2019, but we don’t see a U.S. recession before 2020. While some indicators have recently softened– notably manufacturing and housing activity– consumers have been resilient going into year end, with spending supported by tax cuts and an unemployment rate sitting below 4%, a record low for the U.S. We expect Q4 consumer expenditure grow at an annualized rate above 3%, a pretty solid pace. Given that U.S. consumers account for 70% of economic activity, it’s hard to see a recession at this point. It’s equally hard to envision firms switching from an environment of labour shortages to laying-off workers without much of a transition. The economic situation in Canada is similar with a cooling of growth but no recession on the radar. In Q4, Canada added 115k jobs, whereas non-farm payrolls in the U.S. jumped by solid 762k jobs.
As much as investors feared higher interest rates back in October, the collapse in government bond yields in Canada and U.S. has effectively removed a key headwind to economic growth and stock markets. Capital markets are a great discounting mechanism, but they don’t always get it right. As the quote from Nobel Laureate Paul Samuelsson says about equity markets predicting nine of the past five recessions, investors tend to overreact to uncertainty and fear, and thus tend to over predict recessions.
…But the Yield Curve is So Flat
Investors are obsessed with the yield-curve flattening, especially the 2- and 10-year points of the curve, which ended the year at less than 20bp away from inversion, it’s flattest since 2008 (Chart 2). While we recognize the forward-looking aspect of bond yield curves, we also think the U.S. curve is flatter than it should be at this point of the cycle because of a few factors. First, the Fed is hiking and yield curves flatten when a central bank hikes. Second, the Fed has deliberately made the curve flatter with Operation Twist in 2011, when it sold short-term Treasuries and bought long-term ones, which pressured long-term bond yields downward. Third, the U.S. Government is running a behemoth fiscal deficit but relies mostly (85%) on short-term paper (less than 5 years) for its funding. The flooding of bonds in the front end of the yield curve thereby exacerbates the flattening. Finally, add to it that it’s been a great trade since 2014 with 250bp of flattening, it’s no wonder investors have piled into that steady wagon.