The Interest Rate Environment
Today we’re going to cover some interesting things happening in the interest rate environment. We will cover the International Monetary Fund (IMF) and their outlook for the global economy over the next 12 to 18 months, what the markets are doing, and a little about earnings. And to round it all out, we will discuss the change in the yield curve.
News, China, Earnings, and the IMF
Figure 1 Source: ChaikinAnalytics.com
I want to start with the stock market, and Figure 1 shows the stock market over the last three months. You can see that if you fell asleep three months ago, and you woke up today, you would think, “Well, nothing has happened.” But there has been volatility – it’s not been nearly as bad as what we’ve seen over the past 18 months.
China Trade and Market Reactions
We have seen a lot of market trading based on news. And a lot of that news is based on what’s going on in China and the trade talks. Today, I want to break it down into more of a fundamental piece. Look, the markets have been crazy, they’re going to be crazy. The stock market is going to continue to react to this news until we get either a favorable or an unfavorable outcome on the China trade policies.
Earnings Season, Looking Up
We have entered into the fourth quarter of this year, and companies are announcing their third-quarter results. The estimate was that the companies in the S&P 500, on average, would come in somewhere between 4% and 5% lower than what they were during the same quarter a year ago. Right now, early into earnings season reporting, there are some pretty good results. Some companies are beating those estimates, and the markets are reacting favorably in turn. We’ll see if that trend continues and if it picks up steam over the next couple of weeks.
From a fundamental standpoint, companies are doing a little bit better on earnings than what they had anticipated they would do. It’s not that they’re beating the earnings that they had a year ago in the same quarter, but they’re beating the estimates. They aren’t as negative as what they thought they would be. So, markets seem to be more fairly valued at this point.
The World Economic Outlook from the IMF
On Tuesday, October 15, 2019, the IMF, the International Monetary Fund, came out with its World Economic Outlook report. They say that the chance of a global recession is high over the next 12 to 18 months. And the one thing about recessions is they don’t tell us on a calendar when they are going to come. We don’t know when that recession is going to happen.
The Interest Rate Environment
We’ve been talking about one of the indicators that we believe has been a very accurate predictor of recessions over the last several recession, and that is the inversion of the yield curve. With that, I want to spend some time talking about the inverted yield curve and the interest rate environment.
Recessions and the Yield Curve
Figure 2 Source: FRED.StLouisFed.org
Figure 2 shows us back from 1980 up to our current day in 2019. The circled areas are where we see inversions of the yield curve start to happen. Those all led to recessions, as noted by the shaded areas here. But what’s interesting is the inverted yield curve never stays inverted for very long. And in fact, it isn’t inverted when the recession happens in any of these instances. You saw in all of these occurrences; the yield curve comes back to a more normal yield curve before the recession ever happens. So, that might lead people to believe, “Okay, the inversion of the yield curve happened. Now we’re back to a more normal yield curve. So, everything’s okay.” Well, let’s look at where we are today compared to October of last year.
The Yield Curve and Interest Rate Environment
Figure 3 Source: GuruFocus.com
Figure 3 shows the yields on the One-Month, Three-Month, One-Year, Two-Year, etcetera, and the 10-Year with October 2018 on the top line and current yields on the bottom line. If you remember, in our last Monthly Economic Update when we were looking at this, the 10-Year yield was lower than the One-Month, Three-Year, and One-Year yield. The thing is that we’ve seen this yield curve go from being inverted to now the 10-Year Treasury yielding higher than that One-Month, Three-Month, One-Year, and Two-Year treasuries.
Many people might say, “Well, okay, that’s it! There’s no chance of recession now because that your curves no longer inverted!” However, one thing to keep in mind is just because the yield curve goes back to a more normal yield curve doesn’t mean that the recession, fears have abated, or the possibility of a recession is no longer present.
Reviewing Past Recessions and Yield Curves
Figure 4 Source: YCharts.com
To give you a little bit better look at this, I want to look at the 10 to Two-Year Treasury yield spread in Figure 4. This is 2005, and into late 2005, the yield curve inverted for the very first time.
Figure 5 Source: YCharts.com
In Figure 5, we roll into 2007, and you can see the yield curve inverted at the beginning of the year. Then it came back out of the inversion and inverted again in May. After those inversions, it then came back up, and we had a nice normal yield curve. However, as you can see noted by the shaded area, the recession began after the normal yield curve returned.
So, an inverted yield curve doesn’t mean that the recession is today. What it means is that the possibility of a recession is out there? We are ever vigilant in looking at what’s going on with the yield curve and the interest rate environment.
Yield Curve and the Interest Rate Environment in 2019
Figure 6 Source: YCharts.com
To bring that into focus today, Figure 6 shows us 2019 so far. Back in January of 2019, we had yields about maybe 15 to 16 basis points on the 10-Year higher than the Two-Year. The inversion occurred, and now it is back up to where it’s not inverted anymore. Does this mean that this little blip of the two to 10-Year inversion means that we don’t have the chance of recession? Was this just kind of a head fake? We don’t know. There’s nobody that puts recessions on the calendar. Our team will keep a watchful eye on the yield curve and the interest rate environment.
In a marketplace like this, contractions of some sort follow all expansions. We still believe there is a chance of a mild recession occurring sometime in the next 12 to 18 months. We also think we have to look at the market and realize that in election years, we typically have pretty strong markets. They’re never straight up; however, there’s still some volatility that occurs.
Keep Things in Perspective
The one thing still driving the markets crazy is this news-driven environment. Things like the tweets from President Trump and the negative news coming out of China are having an impact. All kinds of things are going to go out there, and as a result, they’re going to continue to drive the markets crazy. But until we see the signs more clearly saying, “Hey, things are really falling apart!” We’re going to maintain the allocations that we have in your portfolios today.
We don’t see any significant changes coming here in the next 30 days. I plan to visit with you again sometime in the first or second week of November to give your thoughts on what’s going on then.
As always, here at Modern Wealth Management, all your advisors are here to talk to you to help you understand what we’re seeing, what we’re thinking, how your portfolio is constructed, and, more importantly, how that fits into your overall retirement plan. Regardless if you’re a client or not if you have questions about your retirement plan, reach out to us. To request your meeting with a financial planner, schedule a complimentary consultation below, or give us a call at 913-393-1000. We’re always ready to help you plan for your future.
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The views expressed represent the opinion of Modern Wealth Management an SEC Registered Investment Advisor. Information provided is for illustrative purposes only and does not constitute investment, tax, or legal advice. Modern Wealth Management does not accept any liability for the use of the information discussed. Consult with a qualified financial, legal, or tax professional prior to taking any action.