Perspectives & Commentary

Avalon produces a variety of investment commentaries.

Our perspectives and quarterly commentary are issued throughout the year and cover a range of investment-related topics.

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Source: Bloomberg, Avalon Investment & Advisory as of August 19, 2019

Chart of the Week: Market volatility increased last Wednesday when the yield curve inverted (2-year U.S. Treasury yield was higher than the 10-year) briefly. Though the S&P 500 recovered most of the losses for the week, the index declined -2.9% on inversion day. Should investors fear this inversion? Interestingly, the bond market never closed with the curve inverted this time which is different than the past instances illustrated in the chart. Setting that issue aside, yield curve inversion has a strong track record of predicting future recessions but has proven to be a very poor tool for timing stocks. In four out of the past six inversions, stocks were higher in the one year following inversion with an average gain of more than 9% (green line). The other complication with yield curve inversions is that the recession signal tends to be well in advance of the recession with an average of about 18 months, but the timing is variable. There is also reason to believe that the inversion recession signal might be less effective at very low interest rates. There is no doubt that the U.S. economy is slowing, but Avalon still sees recession as a low probability in the next year. Avalon continues to monitor the situation closely, but investors should be prepared for more volatility as the markets struggle with discounting the uncertainty surrounding the geopolitical risks and the economy.

  WEEK IN PREVIEW

  • Geopolitical: Markets will monitor the progress of trade negotiations between the U.S. and China as the trade dispute has escalated from an uneasy truce. Movement of the Yuan/U.S. dollar and developments surrounding possible September trade talks will be closely watched. The Italian government could be facing a confidence vote after PM Conte speaks to the senate.
  • U.S.: July housing data should show some benefit from lower mortgage rates with existing and new home sales on tap this week. Markit August manufacturing PMI probably stayed close to the growth demarcation level of 50 at 50.5. Federal Reserve (Fed) releases its July meeting’s minutes when it cut rates the first time in a decade. The Fed’s Jackson Hole policy symposium could give hints to future policy moves with Chair Powell scheduled to speak on Friday. The Atlanta and NY Fed currently estimate 3Q GDP growth at 2.23% and 1.82%, respectively. 2Q earnings season is winding down but there are several retailers scheduled to report.
  • Europe: Eurozone consumer inflation (CPI) for July likely weakened to -0.4% month-over-month (M/M) and 1.1% year-over-year (Y/Y). Markit Eurozone manufacturing for August probably weakened further to 46.2, far below the growth level of 50. Similarly, Germany’s Markit manufacturing PMI is still searching for a floor and is expected at 43.0 for the month. With the continued softness in Eurozone data, further stimulus from the European Central Bank (ECB) is almost a certainty in September. Brexit is fast approaching on October 31 and U.K. parliament is set to debate no deal Brexit on September 3.
  • Asia: Japan July imports and exports showed some improvement though remain in contraction Y/Y at -1.2% and -1.6%, respectively. Other readings such as the August PMI data, June all industry activity index and July machine tool orders will be watched for signs of improvements.
  • Central Banks: The central banks of Zambia, Indonesia and Egypt meet with Egypt expected to cut rates by one percentage point. There is speculation that Indonesia could make a surprise cut.

  WEEK IN REVIEW

  • The S&P 500 closed -1.0% lower last week after the yield curve briefly inverted. Consumer staples (1.6%), utilities (0.5%), and real estate (0.3%) were outperforming; while Energy (-3.9%), financials (-2.2%), materials (-2.0%) were the worst performers. WTI (0.7%) and Brent crude (0.2%) oil prices slightly rebounded from the steep drop, yet the energy sector (-3.9%) and MLPs (-0.7%) were still down. Small cap stocks underperformed with the Russell 2000 down -1.3%. The 10-year U.S. Treasury yield declined to 1.55%. High yield credit spreads reflected decreased risk tolerance by widening.
  • The U.S. dollar was stronger against developed and emerging market currencies. Developed international stocks as measured by MSCI EAFE underperformed the S&P 500 returns in U.S. dollar terms (-1.6%) and outperformed on a hedged-currency basis (-0.97%). Emerging market stocks underperformed the U.S. with the non-hedged return down by -1.1% for MSCI EM.
  • The 10-2 yield curve inverted for a brief time during the week but reversed and ended at a positive 7.3 basis points. Another curve measure of three-month yield six quarters forward – three-month yield inverted slightly more and ended the week at -61.8 basis points. The yield curve has historically provided an accurate forecast of future recessions when the difference in these measures turns negative, also known as inversion. Yield curves are one of the major indicators that we monitor to judge recession risk, but these inversions typically happen a year or more in advance of an economic recession. In addition, stocks have historically had significant advances post-inversion. The three-month yield six quarters forward yield is now reflecting that the market expects another two to three net cuts in short-term rates over the next year and a half. Our view remains that the odds of a recession in 2019 remain low and Avalon expects one to two additional rate cuts from the Federal Reserve in 2019. Avalon continues to monitor the data closely. Please see our Avalon Perspectives publication, The Yield Curve and Equity Returns, from April 26, 2018, for more details.

Phan Phan Duong, Senior Analyst

 

Henry J. Lartigue, CFA, Managing Partner

 

Samuel E. Rines, Chief Economist

 

Bill Stone, CFA, CMT, Chief Investment Officer

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This report is furnished for the use of Avalon Investment & Advisory and its clients and does not constitute the provision of investment or economic advice to any person, nor the recommendation of any security. Persons reading this report should consult with their investment advisor regarding the appropriateness of investing in any securities or adopting any investment strategies discussed or recommended in this report. Statements regarding future prospects may not be realized. The information contained in this report was obtained from sources deemed reliable. Such information is not guaranteed as to its accuracy, timeliness, or completeness by Avalon Investment & Advisory. The information contained in this report and the opinions expressed herein are subject to change without notice. Past performance is no guarantee of future results. Neither the information in this report nor any opinion expressed herein constitutes an offer to buy or sell, nor a recommendation to buy or sell, any security or financial instrument. Avalon Investment & Advisory does not provide legal, tax, or accounting advice. ©2019 Avalon Investment & Advisory. All rights reserved.

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