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Stocks post steep losses on trade worries, economic slowdown fears

Anything can happen in the stock market and you ought to conduct your affairs so that if the most extraordinary events happen, that you’re still around to play the next day. – Warren Buffett

In a week to forget, all of the major stock averages suffered steep losses, making it the worst start in the month of December since 2008. The week actually began with strong gains on Monday after the U.S. and China agreed to postpone any additional tariffs at the G-20 summit meeting. A 90-day truce was agreed upon to allow more time for negotiations to resolve their trade differences. But the positive reaction to this cease-fire was short-lived and doubts surfaced almost immediately that a deal would get done. The arrest of Chief Financial Officer Meng Wanzhou of Huawei Technologies, one of the largest mobile phone makers in the world, on charges of violating sanctions against Iran cast doubt that a trade agreement could be reached and weighed on sentiment. Without an agreement, investors feared that trade relations between the two countries would only deteriorate, negatively impacting economic growth and corporate earnings. Persistent worries over an economic slowdown also rattled investors and bond yields fell across the yield curve. The yield on the 10-year Treasury fell to 2.85% while the yield on the 2-year Treasury dropped to 2.72%, a difference of only 13 basis points (a basis point is one hundredth of one percent). An inversion of the yield curve, where yields on short-term Treasuries exceed those of long-term Treasuries, can portend the onset of a recession. Last week the yield on the 3-year Treasury actually closed higher than the yield on the 5-year Treasury, but, historically, this occurrence has not had any immediate, adverse effect on either the economy or the stock market. Instead, stock market returns have been above average and recessions have typically occurred only years later. For the most part, economic data released last week was mostly positive, confounding investors on the magnitude of the sell-off in stocks. The most important piece of economic data, the November employment report, showed that 155,000 new jobs were created and that the unemployment rate remained at 3.7%. Although expectations were for the creation of about 200,000 jobs, this was actually a Goldilocks report, neither too hot that the Federal Reserve might be more aggressive in hiking rates nor too cold that investors would be justified in fearing an abrupt economic slowdown.

Last Week

The November employment report also showed that average hourly earnings rose modestly and increased 3.1% from a year ago, an increase that is not considered inflationary. The ISM manufacturing index in November was better than expected and comfortably in expansion territory while the ISM non-manufacturing or services sector index recorded its second-strongest reading in 13 years. The preliminary University of Michigan consumer sentiment index in December was unchanged at 97.5, a high level that the index has maintained over the last two years. Construction spending in October edged slightly lower and was less than expected while factory orders in November declined for the third time in the past four months but were in line with estimates.

The Federal Reserve Beige Book showed that most of the Federal Reserve’s 12 districts experienced modest to moderate growth for the past six weeks and that consumer spending was fairly strong. New home construction and existing home sales were steady to slightly lower. The report was consistent with the Fed’s goal of gradually raising interest rates.

For the week, the Dow Jones Industrial Average dropped 4.5% to close at 24,388 and the S&P 500 Index declined 4.6% to close at 2,633. The Nasdaq Composite Index plunged 4.9% to close at 6,969.

This Week

Inflation data that will be released this week are expected to be benign as both the November producer price index (PPI) and the consumer price index (CPI) should be flat while import prices are forecast to fall after rising in October. November retail sales are expected to increase modestly after posting a large increase in October.

The European Central Bank (ECB) meets and is widely expected to leave its benchmark interest rate unchanged at -0.4%.

It will be a quiet week for quarterly earnings reports and the most notable companies on the agenda include Vera Bradley, Casey’s General Stores, Costco Wholesale and Adobe Systems.

Portfolio Strategy

Despite the weaker than expected jobs numbers last week, the Federal Reserve will likely raise interest rates by 25 basis points to a range of 2.25% and 2.5% at its meeting on December 18th and 19th. The three-month moving average of job gains has been solid and strong enough for the Fed to act. By foregoing a rate hike this month, the Fed could be sending the wrong message to investors about the current state of the economy. Looking ahead to 2019, however, the federal funds futures market is now signaling only one rate hike, a big change from the Fed’s recent projection of three additional rate hikes. While the yield curve has definitely flattened with a spread of only 13 basis points between the yield on the 2-year Treasury and the 10-year Treasury, it has not inverted. The yield curve is normally upward-sloping with longer-dated Treasuries providing a higher yield than a shorter-dated Treasuries. Although the yield differential has narrowed considerably, it’s important to emphasize that it is still positive. By reducing or ending its interest rate hikes, the Federal Reserve could help prevent an inversion. Since 1962, no recession has occurred without an inversion of the yield curve and even if one does occur, the stock market tends to do well for at least a year. At the moment, the stock market appears to be overreacting to fears of an inversion and a possible recession. The economy is expected to slow from 3.5% GDP growth in the most recent quarter to about 2% growth next year, not fall off a cliff. For fixed income investors, portfolios should be overweighted in shorter-term securities or bond funds since longer-dated bonds are more sensitive to changes in interest rates than shorter-dated bonds and short-term yields are nearly comparable to long-term yields.