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What’s Slowing Santa’s Sleigh?

December 18, 2018 by Miranda Carr

 

 

With the approach of the Holiday Season, many investors are wondering if they will enjoy a “Santa Claus” rally in the final weeks of 2018.  So far, the headlines have not been filled with Holiday cheer.  Global equity markets have fallen sharply as investors have grown increasingly worried about global trade, a hard Brexit, and slowing economic growth. In the US, company-specific news has spooked investors, as Johnson and Johnson’s legal issues sent the entire index down late last week. No doubt volatility has increased along with uncertainty, and we are barraged with headlines blaming the price moves on everything from the looming government shutdown, a possible repeal of the Affordable Care Act, to the inversion of the yield curve.

Historical Context

While the headlines may highlight the severity of the recent pullback, the reality is that these market declines are well within the norm of longer-term market cycles. Since January 1980, the S&P 500 Index (U.S. Large Cap stocks) has experienced an average intra-year decline of approximately 14 percent. Over that period, the index had declines of more than 10 percent within the year for nearly half of the years observed and more than 15 percent roughly a third of the time. Nevertheless, the S&P 500 Index still produced positive returns in 29 of 38 calendar years. Investors who sold following a sharp decline would have likely sacrificed significant long-term gains, having missed out on the subsequent market recovery.

Stay Disciplined

We recognize that market pullbacks, as we have recently experienced, can be trying times for investors. During periods of heightened market volatility, investors may feel the urge to make sweeping portfolio changes, though such moves are often ill-timed and can significantly impair the effectiveness of a prudently designed investment plan. The focus should be on making sure that your investment plan reflects your goals. Are you diversified, so that your portfolio is buoyed when certain asset classes go down? Are you saving enough? This is the single most important consideration in meeting your retirement goals. If you have been doing the things you need to do, then you can take comfort knowing you have a sound financial plan and the discipline to adhere to it, even when markets pull back. If you haven’t been on the right track, you can establish some good financial habits amid the volatility and head into the new year with one resolution in the books.

Our investment committee is currently reviewing our long-term capital market assumptions and portfolio asset allocations, and we are looking to update our models in the first quarter of 2019. We continue to believe that investors should be patient and adhere to a well-constructed, diversified investment portfolio anchored to long-term goals and time horizon.

About that Yield Curve

Among all the headlines, investors will most closely be watching the yield curve. Why does an inverted yield curve matter? For a healthy and growing economy, longer-term rates are higher than shorter-term rates as investors demand greater compensation for the risk of inflation and interest rate increases. This is shown in an upward sloping curve, with the time to maturity for the bond along the x-axis and interest rates going up the y-axis. When the yield curve inverts, it generally signals that investors are concerned that economic growth will slow down from current levels as interest rates in the short-term move higher and 10-year rates or even 30-year rates stay the same or move down with expectations about future economic growth.

Historically, an inverted yield curve has been a strong predictor of future recessions, explaining why investors place such an emphasis on the shape of the yield curve. Research by the Federal Reserve Bank of San Francisco has shown that an inverted yield curve (in this case, the difference between one-year and ten-year Treasury yields) “has correctly signaled all nine recessions since 1955 and had only one false positive, in the mid-1960s, when an inversion was followed by an economic slowdown but not an official recession.”

Many investors assume that an inverted yield curve implies an imminent recession though that is not necessarily the case. The San Francisco Fed’s research notes that the delay between an inverted yield curve and a subsequent recession has ranged between six and 24 months. For additional perspective, a recent Reuters poll of economists pegged the probability of a U.S. recession within the next two years at approximately 35 percent with U.S. trade policy cited as one of the economy’s biggest downside risks. It is also interesting to note that a yield curve inversion does not imply negative market returns immediately thereafter. In fact, when looking at data from the past five recessions, the S&P 500 Index still produced positive returns following an inversion.

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