Flying Inverted

Market Commentary – Spring 2019

A few years ago, Denzel Washington starred in Flight, a movie about a skilled airline pilot who, when facing a major mechanical malfunction, intentionally turned his out of control airliner onto its back. This risky move allowed him to regain a bit of control over his stricken craft.

In the investment world we expect the interest rates paid on long term bonds to be higher than the rates paid to investors of shorter dated bonds. When short term rates exceed longer term rates, we say there has been an “inversion.” In late March, the rate paid on three-month Treasury bills exceeded the rate paid on 10 Year Treasury bonds.

Like airliners, economies are not designed to operate while inverted for a long period of time. Rate inversions have reliably preceded economic recessions and so are seen as an early warning to investors of lean times ahead. The willingness of bond investors to accept a lower rate of interest for a 10-year obligation than one that is due in 3 months is a “tell” that bond investors expect the economy to slow down or even stall in the coming months.

Such concerns should be taken seriously but regarded in context. The drop in 10-year rates comes on the heels of the Federal Reserve’s signaling a new unambiguously patient stance after almost two years of relentless and bracing short term rate increases. Did the Fed see risks that the market was missing? After all, economic indicators have slowed, corporate profit margins contracted in the final quarter of 2018, and earnings expectations have been revised downwards. Should the inversion warning be heeded resulting in a more conservative investment posture?

We do not believe so. The Fed’s move toward patience comes at a time when other central banks remain in the “easy money” camp. U.S. households are in very good shape as wages have been rising and personal debt service is low. Under these supportive conditions we think a recession is unlikely.

The stock markets seem to agree as the S&P 500 rose over 13% in the first quarter. Earnings in the first quarter do not appear to be as robust as forecasted but appear to be set for modest positive single digit improvement in 2019. It seems to us that potential catalysts are decidedly more positive than negative. We realize bull markets are not eternal and this one has lasted far longer than most. Still, further progress seems more likely than not.

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