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— 2019 Q3 Update —



We experienced an uptick in market volatility during the third quarter of 2019 due to a variety of conditions and world events.


"This situation is similar to being on a ship (the economy) with a hole in the bottom of it and the person in the ship (The Fed) has a bucket they’re using to scoop the water out of the ship that’s sinking it.  That method isn’t going to hold things together forever, but it might be enough to get us to shore (a trade deal) before we sink (a recession)."


Some of the highlights of this past quarter were:

  • Quarter 3 was marred by negative equity returns and high volatility.
  • Yield curve inversion dominated the media headlines.
  • The Federal Reserve (Fed) cut interest rates 2 times in Quarter 3.
  • Unemployment figures are at a 50-year low.
  • The U.S.-China trade war is impacting the real economy.





After relatively smooth sailing in the first half of 2019, this past quarter was marred by negative returns with high volatility which is a derivative of many underlying root causes.  Before attempting to understand the root causes, it is important to understand volatility on a fundamental level.  Market volatility comes from the cumulative decision making of every market participant who engages in buying and selling of their securities, therefore, high volatility over a quarter represents collective uncertainty in the markets.  Collective uncertainty is different than individual uncertainty because unintuitively, collective uncertainty can be derived from everyone being resolute about their own narrative, which may be different than the next person’s narrative.  Individual narratives being highly polarized causes collective uncertainty.  We live in a time period where individual narratives about the state of the world are extremely polarized even when everyone is looking at the same data.  Luckily, data is still the root cause of what the negative returns and volatility are being derived from.  This begs the question, what was the important data in Q3 of 2019?  The yield curve, unemployment, Institute for Supply Management Indicator (ISM indicator), inflation, and the U.S.-China trade war are all important data points and events that can give us a generalized picture of what impacted Q3’s results.



Source: Federal Reserve Bank of St. Louis



The yield curve is one the most important and most referenced recession indicators because there is a clear dichotomy between the indicator predicting a recession and it not predicting a recession.  When the 10-year maturity of the yield curve is yielding less than the 3-month or 2-year maturity of the yield curve, it is considered a predictor of an upcoming recession.  Outside of the behavioral aspect of the media potentially causing a feedback loop that frightens consumers with recession fears which reduces aggregate demand for goods & services which in turn actually causes a recession; there are real structural reasons for an inverted yield curve to cause a recession. 


The main reason an inverted yield curve slows the economy is that it reduces the margins that banks receive between the differential from borrowing short term and lending long term.  This reduces the incentive for banks to lend which contracts capital in the economy and makes liquidity expensive.  When liquidity is expensive (banks paying more to borrow short term than to lend long term), companies that need continual lending from banks to survive end up going bankrupt.  Bankruptcies and tight credit conditions reduce aggregate demand which reduces corporate profits and causes further bankruptcies.  To avoid bankruptcies, companies lay off workers which increases unemployment and further reduces aggregate demand.  This can cause a deflationary cycle if the yield curve doesn’t revert back into a steep slope. 


The yield curve is an extremely important indicator for behavioral reasons and for structural reasons.  The behavioral reasons tend to cause investors to panic before the structural aspects can come to fruition, which causes a lot of investors to sell too early and miss out on the later cycle returns.  We are currently in an environment where the 10-year and 3-month yield curve have been inverted for an extended period (-17 bps as of 10/1/2019), and the 10-year and 2-year yield curve briefly inverted (9 basis points above 0 as of 10/1/2019).  This is a definite cause for concern but because inflation is still below 2%, the Federal Reserve is continuing to lower short-term interest rates which prevents the curve from steeper inversion.  However, if there are large exogenous shocks to the world economy, such as negative trade war news, investors could react with a ‘flight to safety’ and buy 10-year government bonds which will push down interest rates at the 10-year tenor further inverting the yield curve.  This has potential for another feedback loop because these same investors might have an even stronger ‘flight to safety’ response to a negative yield curve further pushing the yield curve into negative territory. 


Overall, the yield curve is a very important indicator for behavioral and structural reasons.  We are currently in red zone territory with this indicator and it will be important to keep our eyes on it as time goes on.



Source: Federal Reserve Bank of St. Louis


Source: CME Group



The yield curve, inflation, and unemployment are inextricably linked together because according to the Fed’s website, their three main goals are: “maximum sustainable employment, stable prices, and moderate longer-term interest rates.”  These three variables have large effects on each other that change and react to each other over time.  Employment levels affect inflation by increasing aggregate demand by giving consumers more disposable income.  Interest rates affect business investment, saving rates, housing starts, lending practices, and numerous other parts of the real economy.  All of the variables affected by interest rates are components in the calculation of inflation.  As you can see, these are extremely intertwined variables and the Fed is trying to balance the economy by manipulating the interest rate.  Even though the Fed does have three main goals, they are undoubtedly extremely intertwined and reactionary towards each other.  If the Fed was trying to actively shoot for all three at the same time, they would undoubtedly produce unexpected overshoots or undershoots in the other variables.  Therefore, the Fed has one main focus, which is to target inflation numbers.  According to Robert T. McGee in Applied Financial Macroeconomics and Investment Strategy, “Interest rates are ultimately set by the Federal Reserve to keep inflation at around 2 percent.”  This implies that the Fed’s true goal is to target inflation and employment will naturally take care of itself with the stable prices in the economy. 


Historically, unemployment and inflation numbers had an inverse correlation with each other.  Logically, that relationship makes perfect sense; when people are working they’re typically going to have more disposable income, when people have more disposable income they spend more money and that is increasing aggregate demand.  When demand increases, general price levels in the economy increase and inflation increases.  Therefore, as unemployment falls, inflation has historically increased, in economics, this relationship is also known as the Phillips Curve.  Since the 2008 financial crises, that relationship has all but completely broken down.  Unemployment is currently at 50-year lows at 3.5% and annualized September inflation was at 1.7%, which is still below the Federal Reserve’s target number of 2% and it’s one of the main reasons the Fed is predicted to cut interest rates again in the October meeting.  According to the U.S. Bureau of Labor Statistics, the last time the unemployment rate was at 3.5% was in August of 1969 and inflation was at 5.4% annualized.  These aren’t perfect comparisons because the economy is radically different today than it was 50 years ago. However, it does highlight something extremely important, the fact the economy is extremely different than 50 years ago.  The Fed is fighting exogenous pressures such as the trade war, political uncertainty, business uncertainty, supply side deflation, and many other factors with one of the only tools they have, which is to affect liquidity in the economy.  There is an old saying, when all you have is a hammer everything looks like a nail.  It is possible the Federal Reserve is fighting a fight they cannot win simply because their tools aren’t working the same way they used to work and they have a general interest rate floor of 0%.  The breakdown of this relationship is something to keep our eyes on because it might affect how the market comes to understand the Fed’s influence on the markets in the future.  




U.S. Tariffs: US$550 billion worth of Chinese products

China Tariffs: US$185 billion worth of U.S. goods

Source: China Briefing



The U.S. China trade war has been the largest cause of uncertainty in the markets during 2019.  It is filled with constant speculation, Twitter posts, and news cycles that can make any investor’s head spin on which move to make next.  This same uncertainty has spilled over into the real economy and has caused a vast amount of uncertainty in businesses which has reduced business investment.  Reduced business investment has caused business confidence, measured by the ISM Purchasing Managers Index (PMI), to reach cycle lows and put the United States manufacturing sector into a technical recession.  Luckily, the manufacturing sector of the economy is much smaller in 2019 than it was in 2008 but it is still far from a positive for the overall U.S. economy. 


The key take-aways from the trade war are that there is much more noise than action. The noise has an actual effect on the real economy, and the tariffs are affecting both economies negatively.  The noise comes from both sides constantly jockeying for position and the noise affects the real economy by increasing uncertainty which reduces business investment and business confidence.  This situation is already causing a generalized slowdown in the economy. All hope isn’t lost because inflation is still below 2% so the Fed is most likely going to continue to cut interest rates.  This situation is similar to being on a ship (the economy) with a hole in the bottom of it and the person in the ship (The Fed) has a bucket they’re using to scoop the water out of the ship that’s sinking it.  That method isn’t going to hold things together forever, but it might be enough to get us to shore (a trade deal) before we sink (a recession).



As investors, it is important to look at the long term rather than the short term.  It might be difficult to withstand the volatility the trade war is causing in your portfolio but through all the volatility comes opportunities for returns for the investors that can withstand that volatility.  This trade war also exemplifies the importance of diversification and riding through the volatility in the market as a modern investor.  It is easy to make rash decisions based on the constant bombardment from news outlets, social media, and volatility in the markets but as has been proven time and time again throughout the history of the markets, the investors who are able to curb their fears and block out the noise are the ones who typically come out on top.  All of the events and uncertainty in the markets are reasons to speak with your financial advisor to make sure you are allocated in a way that aligns with your goals and ability to withstand risk in your portfolio.


McGee, Robert T. Applied Financial Macroeconomics and Investment Strategy: A Practitioner's Guide to Tactical Asset Allocation. Palgrave Macmillan Ltd., 2015.

The views and opinions expressed herein are those of the author(s) noted and may or may not represent the views of Lincoln Investment.  The material presented is provided for informational purposes only. Nothing contained herein should be construed as a recommendation to buy or sell any securities. As with all investments, past performance is no guarantee of future results. No person or system can predict the market. All investments are subject to risk, including the risk of principal loss.  Asset allocation does not guarantee a profit or protect against loss.  A recession is a significant decline in activity across the economy, lasting longer than a few months. It is visible in industrial production, employment, real income and wholesale-retail trade. The technical indicator of a recession is two consecutive quarters of negative economic growth as measured by a country's gross domestic product (GDP); although the National Bureau of Economic Research (NBER) does not necessarily need to see this occur to call a recession.

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