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As the year draws to a close and we look back at 2018, it has turned into a very good year for the U.S. economy. Not only did overall GDP growth accelerate, but many of the segments that were worrisome at the beginning of the year proved resilient in the face of adversity. In many respects, 2018 was the Goldilocks economy we had hoped for, stronger growth with low inflation. However, this has not translated into strong investment returns year-to-date. Markets around the globe have struggled. Certainly, they have not performed as one would expect with a robust economy.
Markets deviating from economic reality is not a groundbreaking phenomenon; it happens at times. Economic reality diverges from investment returns over short periods of time. Each time is different, but this time the reasons center around expectations of slower growth moving forward. Although the U.S. is still expected to grow, the rate of growth next year may be less. Two percent growth isn’t as good as three percent growth. In economic terms, this delta is called the second derivative of a dataset, and it has important ramifications throughout the investment world. Capital market assumptions include expectations for future growth. If future growth is lower, naturally the value of investments should be lower as well.
Strong economic growth also doesn’t mean everything is perfectly rosy. As I wrote last month, two of our Economic Dashboard indicators were on the verge of turning yellow. With December’s update, one indicator has turned yellow, the S&P 500 & 20-Month Moving Average. The good news is this is the only market-based indicator on the Dashboard and without signs from any of the other economic-based indicators, it may only be a minor glitch. It could easily turn back to green next month. However, it is worth taking notice and focusing our attention.
Markets are volatile at times, but they can also be forward-looking. Even without signs of economic distress, markets are telling us something that isn’t showing up in the data yet. It tells us that even though confidence is at high absolute levels, it may be declining. Not so coincidentally, the other indicator on the verge of turning yellow is the Year-Over-Year Change in Consumer Confidence. Taken together this means there may be a potential hit to confidence on the horizon that could lead to further market declines. However, unless the decline in confidence leads to absolute declines in economic data, the volatility may only be temporary.
U.S. interest rates are also on our radar. The first U.S. yield curve inversion occurred this past month. The interest rate on a 3-year treasury bond moved higher than the rate on a 5-year bond. While this is not one of the significant interest rate spreads used as a recession indicator, it is the first of many inversions we may experience over the coming years. Each one will carry more weight and will better signify a slowdown in the economy. Most importantly, as a research article by the Federal Reserve Bank of St. Louis recently stated, inverted yield curves don’t cause recessions, but they do signify a deceleration of growth, that when combined with a negative external shock can send the economy into a recession. We don’t know what the shock will be this time around, but when conditions of slower economic growth grow more widespread, we have to take notice and prepare.
Our first yellow indicator deserves attention, but it does not have much significance on its own. As a reminder, green signifies a positive indicator, yellow signifies some weakness in the data, and red signifies extreme caution over the current readings. While yellow doesn’t feel good, it does not rise to a high level of concern. In fact, throughout any bull market and economic expansion we expect to see many yellows. Even a single red would not lead us to take action. The Allegiant Investment Research team is looking for three red indicators before making significant changes (i.e. a significant reduction in risk). Historically, three red indicators has been a really good predictor of an impending recession. It is at that point that we would reevaluate every portfolio and, in many instances, dial back the risk, as long as that is also the prudent investment decision for the individual objective. (Side note: this is not meant to pick the absolute top of the market. Instead, it is designed to sidestep some of the severe declines associated with recession-based bear markets, which are usually the most severe.) As investors we accept the volatility of confidence-based market declines, but we to limit (not eliminate) the severity of losses during recession-based declines. For now though, the data does not lead us to make any major changes. The best advice is to stay the course until the data changes.
If you would like to see more data and charts about the economy and various financial markets, please see our Monthly Insights book.
Benjamin W. Jones, CFP®, AIF®
CERTIFIED FINANCIAL PLANNER™
Chief Investment Officer, Principal
240 South Pineapple Avenue, Suite 200
Sarasota, Florida 34236
Telephone (941) 365-3745
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