Q&A: What's driving the markets today?

05-01-2018

Recent market volatility is reflecting the tension between exceptionally strong earnings vs. the threat of higher inflation and yields. Portfolio Manager Steve Chiavarone shares his insight on this dynamic.

Q: Why does 3% on the 10-year seem to be generating so much market volatility? It’s a sign that inflation is building—rarely a good thing for government bonds—as growth has improved and labor markets have tightened. But that’s not such a bad thing for stocks or even credit sectors of the bond market.

The key question is pace. We think that inflation will build gradually, that rates will grind higher (with the 10-year Treasury yield ending the year around 3.25%) and that the Fed will remain on a measured pace. We don’t think the 10-year threatens P/E valuations until long rates hit the 3.5-4% range.

Q: In a similar vein, there’s a lot of discussion about a flattening yield curve portending an eventual recession. Does the rapidity of the shrinking gap between 2-year and 10-year Treasury yields in the past year suggest an economic slump sooner rather than later? Yield-curve flattening is normal at this point in the cycle, but it can take a long time to go from where we are currently to an outright inverted curve (where short rates are higher than long rates), and it typically takes two years from such an inversion to recession. So we’re talking 2020-2021, still a good ways away.

Moreover, while an inverted yield curve is usually a sign of a recession ahead, it is not a sell sign. Historically, the average return for the S&P 500 when the yield curve is at current levels (about 50 basis points between 2-year and 10-year Treasury yields) until an outright recession is about 68%.

Q: But isn’t inflation a wild card in this ‘longer cycle’ scenario? We agree that rising inflation will lead to a more aggressive Fed, and that is what will cause our next recession. We just don’t think there’s much reason for the Fed to hit the brakes harder at this juncture.

It looks as if core PCE—the Fed’s preferred gauge of inflation—will end this year around 2%, right on the Fed’s target. And there are indications the Fed may be willing to allow inflation to run a little hotter than that to make up for its disinflationary characteristics for much of this expansion.

Q: If a recession is possible, if not likely, in a few years, won’t the markets start pricing that in relatively soon? First off, we are in a very sweet spot for earnings, and earnings are what fundamentally drive the market. We expect S&P earnings growth will have topped 20% in Q1 once all the reports are in and potentially could be even better in Q2 and Q3. So long as fundamentals and most importantly earnings remain strong, we see a bumpier ride to the same good place—3,100 on the S&P by year-end.

That said, recession doesn’t necessarily mean Armageddon. Even if the economy contracts for a period, as it inevitably will do, we believe we will remain in a secular bull market as technology (new industrial revolution) and demographics (millenialls) push markets higher long term. Remember, a secular bull market does not equate to the absence of recession or down markets; cyclical bear markets and economic slumps are the rule, not the exception, in long-term secular uptrends.

The key for investors during these periods is managing their portfolios in such a way that they don’t get spooked out of the markets during periods of volatility, down markets or recessions so that they are able to add at the bottoms and enjoy further upside. Think managing through the downside in 1987 in order to participate in the rest of the bull market run from that point to 2000.

Thanks, Steve