Dec 05, 2018

Cause for Concern? The Market Selloff Explained

By Gene Balas

Photo credit: Getty Images

Market action

On Tuesday, Dec 4, the Dow Jones Industrial Average suffered a nearly 800-point loss – a 3.1% decline – and the S&P 500 dropped by a bit more and the NASDAQ Composite fell by 3.8%, in data from Bloomberg. This comes on top of heightened volatility and a correction in many U.S. market indices over recent weeks and months. Should we be concerned?

What triggered the selloff?

First, we need to answer the question of what led the market selloff. Going to the root of the issue is a financial market indicator measuring how steep (or not) the Treasury yield curve is. When the yield curve has “inverted” it means that short term rates yield more than longer term rates, directly in contrast to the usual positively-sloping yield curve that rewards investors for taking more risk in bond investments.

Now, investors are less concerned about rising rates into the future because they believe the greater risk is being invested in riskier assets, like stocks. Indeed, historically an inverted yield curve has preceded most recessions, leading by a number of months. As a portion of the yield curve inverted Monday, and the usual measure of the steepness of the yield curve – the difference between yields on the 10 year Treasury and those of the 2 year Treasury – followed suit by collapsing to a virtually-flat reading Tuesday. Investors took this as a signal that we may have a recession, though we note that we had a very flat (but not inverted) yield curve in the late 1990s, and no recession ensued.

Is the yield curve sending accurate signals now?

The answer to this question is yes and no, though only in hindsight will we truly be able to verify its accuracy. First, a number of countries globally are struggling to grow, handicapped by a variety of issues that vary from country to country. This may not affect the U.S. directly, as we depend less on global trade than some other developed markets, but we are connected to the rest of the world through financial market linkages, such as currency exchange rates, commodity prices, and flows of funds into and from U.S. markets. Ned Davis Research published a report recently that highlighted recession risks worldwide, though this well-regarded research firm did not view the U.S. as in the recessionary camp.

Corporate debt

Still, there are risks. We have large amounts of corporate debt relative to GDP that could present risks to financial markets and the economy if rates rise to the point companies have trouble servicing this debt. Any future higher debt service costs as maturing debt might need to be rolled over into bonds with potentially higher interest rates can lead to companies cutting back on hiring and investing, or perhaps add to default or downgrade risk.

Trade wars

Trade wars are also a cause for concern. Aside from providing friction to economies through global trade, business and investor confidence is damaged. Even if tariffs are a small part of the U.S. economy, many business leaders nonetheless become concerned – and investors sense their caution on hiring, expanding, or investing in a more-uncertain environment. Thus, investors may then sell shares.

Plain old simple math

But perhaps the most important risk is simply mathematics. We need to interpret what’s behind measures of growth that indicate a slowing economy or corporate profits. And it is only a risk if investors misconstrue the cause what may be a natural, easily-explained slowing of the economy to a sustainable rate, and not a looming catastrophe.

What do we mean by this? We are currently enjoying relative robust growth. However, much of that growth has come from the Tax Cuts and Jobs Act, which prompted a temporary, one-time boost to consumer spending and, earlier, business investment.

After all, once the impulse of a tax cut is felt in the economy, consumer spending may have a one-time boost in growth to reach a higher level – but since we do not have repeated tax cuts, the future growth of the economy will return to its longer-term trend, related to things such as demographics and productivity gains. Understanding that the growth is spending in, say, the level of spending this quarter divided by the level of spending last quarter. When the level of spending is boosted to a higher amount from more disposable income from the tax cut, the growth in the following period simply won’t be as much when it’s compared to that higher base amount that already reflects the tax cuts.

The long term potential growth rate of an economy is simply the growth of the labor force plus productivity gains. In other words, growth is determined by how many more people are working and how many hours they work, plus how much more they produce in each hour. Growth in recent quarters that was goosed by tax cuts and other fiscal stimulus is simply notably higher than this longer term potential rate. From this point forward, growth will normally and naturally revert to its longer term – that is, lower – potential rate of growth; after all, we don’t keep getting tax cuts every year.

Putting it all together

When considering the worries and risks above, such as trade, for example, it might be natural for an investor to attribute any slower growth (even that of a normal return to sustainable, but slower, growth we just mentioned) to be from this risk source alone. That would appear to magnify the effects of just one or two risks, and these risks might be perceived as having a greater effect than they actually are.

Investors can pull the trigger and hit the “sell” button before considering that tariffs and trade, or longer term risks from rising interest rates (including any Fed policy mistake along the way), may only explain part of slowing growth. As we mentioned above, we would expect growth to slow to a sustainable rate.

The risk is, quite simply, other investors may not see it that way. In a world where perception is reality, selloffs can build on themselves and may not always reflect the whole panoply of influences on the markets and economy. When taking a complex global economy and trying to distill it into a few themes, sometimes investors overreact. This is not to say there are no risks. There are, and we mentioned a few of them here. Some may evaporate, and some may intensify.

Of course, only time will tell. In a world where perception is reality and emotion is fact, a stock market selloff and worried business leaders can create a self-fulling prophecy. Humans, with all the emotions they bring to a decision, ultimately decide whether to spend, hire, invest, or save. The economy and markets are somewhat of a gigantic Ouija board, where millions of independent decisions can push its direction into a recession or bear market – or instead into a favorable outcome, should people’s concerns become assuaged and worries fade.

We can assume, however, volatility (in both directions) is likely to continue. Simply be prepared, knowing that markets may be efficient, but they are not necessarily always rational. Over time, though, long term investors with steely resolve to look past short term market gyrations may turn out to have had it right in the end.

Disclosure

Investing involves risk, including possible loss of principal, and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions. The information contained in this piece is intended for information only, is not a recommendation to buy or sell any securities, and should not be considered investment advice. Please contact your financial adviser with questions about your specific needs and circumstances.

The opinions expressed in this article are those of the author and not necessarily United Capital Financial Advisers, LLC. The information and opinions expressed herein are obtained from sources believed to be reliable, however their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by United Capital.

Opinions expressed are current as of the date of this publication and are subject to change. Certain statements contained within are forward-looking statements including, but not limited to, predictions or indications of future events, trends, plans or objectives. Undue reliance should not be placed on such statements because, by their nature, they are subject to known and unknown risks and uncertainties. Indices are unmanaged, do not consider the effect of transaction costs or fees, do not represent an actual account and cannot be invested to directly. International investing entails special risk considerations, including currency fluctuations, lower liquidity, economic and political risks, and different accounting methodologies.

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