As we wrote in our 4th quarter commentary, the financial markets were becoming increasingly concerned the Federal Reserve (the Fed) was going to make a policy mistake by raising interest rates too far too fast tipping the U.S. economy into recession. These concerns were exacerbated by a speech given by Fed Chairman Jerome Powell in October of 2018 in which he said, “we are long way from neutral at this point, probably.” The market took this as a signal that the Fed was prepared to keep raising interest rates on a set path throughout 2019. The market reacted violently, we believe in part due to the fear of further interest rate increases with the Dow Jones Industrial Average and the Standard and Poor’s 500 index both experiencing their worst December since the Great Depression.
And the Fed took notice! In early January 2019 Chairman Powell signaled the Fed’s pivot away from its hawkish policy of raising rates by saying mild inflation would give the central bank greater flexibility to set policy in the year ahead and the Fed wasn’t on a “pre-set” path to push interest rates higher. The key line being “wasn’t on a pre-set path to push rates higher”. The Fed’s pivot contributed to a U.S. stock market rally that carried all the way through the end of the 1st quarter. Subsequent Fed meetings solidified this message as voting members of the committee did not anticipate raising interest rates in 2019 AND the committee was prepared to end the sale of securities from their balance sheet (another form of tightening) sooner than anticipated. In our opinion, the message to the financial markets from the Fed was crystal clear. The Fed will likely not raise rates in 2019 and seems to be shifting policy to be supportive of growth given slowing global growth and the absence of inflation.
With one worry down another reared its ugly head. Namely, the yield curve. In periods of economic growth, it is typical that long-term interest rates are higher than short-term interest rates. This makes sense given the lender is foregoing the use of the funds for a longer period of time thereby incurring greater repayment and interest rate risk. In the 1st quarter of 2019, however, short-term interest rates as measured by 3-month U.S. Treasury Bills yielded more than 10 year U.S. Treasury Notes. This is known as an inverted yield curve (short-term rates higher than long-term rates). Higher-long term rates reflect the expectation that growth will continue. But when the difference between the short and long-term narrows, it’s a signal people are less certain growth is here to stay. And an inverted yield curve is generally considered a recession indicator. The U.S. Treasury yield curve has inverted before each recession in the past 50 years and has only offered a false signal once in that time, according to Reuters. And once again, the market responded to these slowdown concerns by beginning to price in a Fed rate CUT in December 2019. Whether or not this in fact occurs will be dependent upon how U.S. economy performs in the coming quarters. While an inverted curve certainly merits attention, it does not guarantee a recession is set to occur. As former Fed Chair Janet Yellen recently commented, “In contrast to times past, there’s a tendency now for the yield curve to be very flat. And in fact, it might signal that the Fed would at some point need to cut rates, but it certainly doesn’t signal that this is a set of developments that would necessarily cause a recession.”
We do believe we are late cycle in this economic expansion. And our mantra remains “proceed with caution.” But that does not mean that we nor anyone else knows the future or can consistently time the vagaries of the financial markets well. We choose to focus on the things we can control. Namely, allocating capital to businesses and securities that we believe offer a compelling long-term risk-reward tradeoff. As Benjamin Graham famously said, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” We choose to focus on the long run as this is the best way we know of to compound capital.
As always, we remain committed to helping you achieve your unique financial goals.
The opinions expressed herein are those of PYA Waltman Capital, LLC (“PYA Waltman”). The opinions referenced are as of the date of publication and are subject to change due to changes in the market or economic conditions and may not necessarily come to pass. This information shall not constitute investment advice or a recommendation to buy or sell any security or service.
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