U.S. equities went on a tailspin on Tuesday, with the S&P 500 Index retreating to 2700 and the Dow Jones Index dropping nearly 800 points.
What has happened?
The markets sold off in broad based manner with Financials and Industrials leading the rout by declining 4.4%. Consumer Discretionary (-3.9%) rounded up the three worst sectors for the day. The sole positive sector performance came from Utilities, up 0.2%. From an industry perspective, companies sensitive to economic growth came under pressure as freight and logistics, autos and homebuilders were all drag on the markets.
Recall that the markets have had a very strong run since Thanksgiving (Nov 22nd), up over 6%. On a year-to-date basis most major U.S. equity indices are still in positive territory. On the fixed income side, Treasuries were broadly stronger with further curve flattening. More importantly, for the first time 5Y-3Y spread became inverted for the first time 2007. The 10Y-2Y spread hit a new post-2007 low of 11 basis points.
Today’s sharp selloff was credited to numerous factors. There seemed to be deteriorating optimism and uncertainty about President Trump’s “ceasefire” with China. From a market perspective, there was also broad comment on the inversion of the 5Y/3Y Treasury yield spread, which was the first such move since 2007. Some market participants fear that this inversion is a precursor to a U.S. recession. A more short term effect of the flattening of the yield curve was on Banks and other financials. There was also some market concerns about algorithmic selling, which could have been behind the abrupt move downward around noon after the S&P 500 crossed below the technically important 200 day moving average intraday.
Even though the recent curve flattening has created nervousness amongst market participants, we believe it is highly unlikely that the U.S. economy enters a recession over the next twelve months. We do expect U.S. economic growth to moderate from 3.1% in 2018 to 2.4% in 2019. However, with consumer confidence still high, manufacturing still in expansionary territory (as noted by the November ISM Manufacturing reading of 59.3), strong labor markets and increasing wage growth, this should create a favorable environment for positive economic growth.
However, in a historical context an inversion of the yield curve (not our base case) did not necessarily trigger an immediate recession. As the chart below shows, it took around 500 days on average to the next recession after an inversion of the yield curve and the peak of the Fed Funds typically occurs ~250 days following the inversion, suggesting the Fed will continue to hike. The peak in yields and equity markets occurred ~300 days following inversion date, suggesting that equity markets historically continued to climb higher following the inversion date.
Last four recessions and asset implication timeline (Dark Blue Line: S&P 500)
We reiterate our rather constructive view on U.S. equities and our 12 months S&P500 target of 2,950 points on the back of more attractive valuations and lower, but solid earnings growth. However, given risks in the market related to the trade conflict, an overly aggressive Fed, the political uncertainty in Europe (e.g. Brexit, Italian budget discussion), we expect volatility to remain elevated for some time. Furthermore, we emphasize the need for a selective approach in equity markets with our regional preference for the U.S. over Europe within Developed Markets and Asia over Latam within the Emerging Markets.
Download this CIO Insights Memo as a pdf here.