For all the knee-jerk reactions and panicked selling that occurs in capital markets, important inflection points are often well telegraphed. We look at three indicators typically associated with the months leading up to the end of an economic cycle and how they're affecting today’s markets.
The U.S. Federal Reserve (Fed) has been adjusting monetary policy in response to robust economic growth for several years. Chairman Ben Bernanke first announced the Fed would be slowing the pace of its asset purchases, known as quantitative easing, in 2013—a move that led to a sharp spike in bond yields, which commentators dubbed the taper tantrum.1 In late 2015, the central bank began steadily ratcheting up the federal funds rate for the first time since the summer of 2004, raising the short-term lending rate nine times from 0.0% to 2.5% at the end of 2018. Although central bank officials have suggested another two rate hikes may be appropriate, current Fed Chair Jay Powell has since moderated that stance, and St. Louis Federal Reserve President James Bullard has gone so far as to say that further rate increases could tip the U.S. economy into a recession.
Adding to monetary retrenchment, in 2017 the Fed began actively reducing the size of its balance sheet, which had reached a high of $4.5 trillion,2 by allowing a portion of the Treasury- and mortgage-backed securities it holds to mature without replacing them. What started at $10 billion a month in assets coming off the Fed’s balance sheet ticked up to $50 billion a month by the end of 2018. In all, more than $400 billion in assets have matured already, and an additional $600 billion is set to roll off in 2019 at the current pace. There’s some debate, however, about how far the Fed will go in shrinking its balance sheet, given the growing evidence of a global economic slowdown. At his confirmation hearing in 2017, Chair Powell discussed a target range for the balance sheet of between $2.5 trillion and $3.0 trillion.3 More recently, the Fed issued a statement saying they expect to operate with an ample supply of bank reserves.4 Either way, quantitative tightening, in theory, should have the opposite effect of quantitative easing: increasing the supply of bonds and lowering prices. Investors are wise to expect the deflating of financial assets.
A flat or inverted Treasury yield curve
While the economy still appears to be on sturdy footing based on leading economic indicators, a flattening or inversion of the yield curve suggests a market peak may not be that far away. The Treasury yield curve has inverted (historically defined as the 2-year Treasury note yielding more than the 10-year Treasury bond yield) before each of the past seven recessions.5 Today, the spread between these two yields stands at 20 basis points (one-fifth of one percentage point).6
It’s important to note that yield curve inversions typically happen months before market peaks. In the past two cycles, the yield curve inverted 6 months and 23 months, respectively, before the subsequent market peaks. Given the trend of flattening, it’s entirely possible that inversion between the traditional 2- and 10-year yields happens in 2019.
A more challenging earnings environment
Late-cycle environments typically also include a moderation of earnings growth. As monetary conditions tighten and borrowing costs increase, many companies lose earnings momentum. In fact, a decline in overall earnings has preceded each of the past two recessions. This year, S&P 500 Index companies are also slashing earnings estimates to account for slower global growth, disappointing holiday sales, and the difficulty of exceeding the tax-cut-fueled earnings jump of 2018. Beneath the overall decline is a much more varied picture. Companies with different degrees of free cash flow and levels of indebtedness are having different earnings outcomes, which in turn is leading to a greater dispersion of stock returns.
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1 U.S. Federal Reserve, 2013. A transcript of Chairman Powell’s remarks can be found here. 2 U.S. Federal Reserve, 2019. 3 U.S. Federal Reserve, 2016. A transcript of Chairman Powell’s remarks can be found here. 4 U.S. Federal Reserve, 2019. 5 FactSet, 2018. 6 Federal Reserve Bank of St. Louis, as of 2/4/19.