The trade deal tailwind for financial markets lasted only a day as the equity sell-off that began in Asia accelerated in the US. The S&P 500 finished down 3.25% on 4 December, and weakness spilled over into morning trade in Europe on Wednesday. Markets were buffeted by a number of cross currents, but the sell-off did come after a 6% rally in the S&P 500 over the past six days. The worst-performing sectors – industrials and financials – also point to the two main catalysts: confusion over what the US-China trade deal actually entails and the implications of falling Treasury yields.
"[R]emember I am a Tariff Man"
President Trump's tweet that he will increase tariffs in 90 days if there's no real progress – and confusion about what the administration considers progress – was the initial catalyst for the sell-off after the prospect of constructive negotiations led the markets higher on Monday. While the likelihood of an ongoing dialog after months of no discussions and the pause on tariffs are still positive developments, it’s clear that negotiations will be challenging and a source of volatility.
After trade concerns, the second catalyst was falling Treasury bond yields and yield curve inversion. This began on Monday when part of the front end of the yield curve (5-year vs. 3-year) inverted, and continued on Tuesday with a 6bps drop in the 10-year yield. It’s important to note that the latest moves in yields preceded the largest equity market declines, as the perception that falling yields indicated growth concerns spooked the equity markets.
Two factors give us comfort that the yield moves aren’t signaling a worsening growth outlook. First, speculative short positions in long-maturity (around 20 years) Treasury bond futures are at their most extreme levels since 2010, meaning many investors were speculating that long-end yields would rise (see chart). Short-covering likely contributed significantly to Tuesday’s yield decline. Second, the yield curve (10-year vs. 2-year) did invert prior to the last seven recessions, but the lag from initial inversion to the start of the recession was over 24 months in the last two cycles, which makes it a flawed crystal ball.
Aside from these two catalysts, other factors added to a volatile day. UK Prime Minister Theresa May was defeated on key parliamentary votes as she tried to get approval for the Brexit deal. The president of the New York Fed, John Williams, said that the strong US economy warranted further rate hikes, which sounded more hawkish than recent comments by Fed Chair Jay Powell. A handful of companies reporting earnings gave a mixed picture on consumer spending, while there was downward guidance on smartphone demand. Finally, US markets will be closed Wednesday in a national day of mourning for President George H.W. Bush.
There was no notable US economic data to offset these negative factors, but Monday's ISM and PMI manufacturing surveys in the US and Eurozone, respectively, both exceeded expectations. This reinforces our view that the underlying economic fundamentals, especially in the US, remain solid and the risk of a recession in the next year is low.
The bottom line: While we’re monitoring trade negotiations, the yield curve and other factors, and continue to expect market volatility, on balance we think the economic outlook is positive and supports our tactical overweight on global equities. But given these risks, we also recommend counter-cyclical positions, including a long in the 10-year Treasury bond.