By: Brien L. Smith, CFP and Brian Prescott, Financial Analyst Intern/TWA
For the last decade the United States stock market has experienced unparalleled levels of calmness. That was until the early days of February when that peace was disrupted. This disruption can largely be attributed to a surprise increase in inflation and Federal Reserve interest rate increases. Nonetheless, financial markets quickly absorbed the new information and prices stabilized. However, as 2018 has progressed two problematic topics have dominated headlines, the US-China Trade War and the Yield Curve.
The stock and bond markets hate many things, however, the thing hated above all is uncertainty. They hate uncertainty in future prices, future policy, and future economic conditions. It is this uncertainty that can cause prices to fluctuate drastically. This brings us to the US-China Trade War which economists nationwide predominately agree; is not good. The biggest reason is that it will not only produce uncertainty in future policy, but also in future prices. Investors in the market do not know the extent that companies will be affected or how long the trade war will last. To date the price fluctuations associated with our trade war news has been minor but notable. However, if the trade war fully escalates then greater price fluctuations should be expected. Fortunately, that is a big if. But, should it come to fruition the prevailing expectation is that nobody will win the trade war, and American consumers will be the most damaged.
Additionally, another persistent headline this year has been the tightening of the interest rate yield curve. In other words, the interest rates between short-term and long-term bonds are almost equal. This is of great importance since historically when long-term interest rates are less than short-term rates a recession usually follows. However, just because the rates are almost equal does not mean that a recession is impending immediately. During the late 1960’s, late 1980’s and late 1990’s the economy saw interest rates tighten but then stay at those levels for many years of growth. This tightening is merely a signal that the economy is shifting but not that the expansion is over. Moreover, all recessions are not created equal and even if long-term interest rates drop below short-term rates it does not mean the next Great Recession will be upon us.
It is evident that the financial markets and economy have shifted into a mid-late expansion phase, possibly even a pure late expansion phase. Historically, surges in technology stock returns have implied a complete shift into the late expansion phase. At the time of this newsletter Facebook, Apple, Amazon, Netflix, Google, and Microsoft stock returns accounted for 4.31% of the S&P 500’s 4.97% return. In other words, six technology companies are carrying the S&P 500 index. Additionally, another good predictor of our current expansion phase is the unemployment rate. Which given our current incredibly low rate of 4% further implies a shift into the pure late expansion phase.
Therefore, we can infer that perhaps the markets are in a pure late expansion phase. Does this mean the we are about to hit a recession? The short answer is, not necessarily. Just because our expansion has lasted a long time does not imply that an immediate recession is more probable. Recessions do not happen on their own, they need a spark. It is true that the spark could be a trade war or interest rates. However, it is equally true that these could be minor bumps on the road to continued years of strong growth. Thus, recession predictions should be taken with a grain of salt and examined carefully.