Three risk indicators to watch this year

Investors have had a tough go of it so far in 2018. Outside of U.S. small-cap stocks, oil, and technology shares, much of the global investment landscape has been marked by low or negative returns and bouts of volatility. Meanwhile, emerging markets have seen sharp reversals after a generally strong 2017.

We’ve remarked before that what ails the market today is less about deteriorating fundamentals than about risks on the horizon. After all, U.S. corporations delivered their strongest earnings in years in the first quarter of 2018, and analysts are forecasting continued strength, with EPS growth estimates topping 20% for the full calendar year.¹ And while growth outside the United States has slowed, it remains positive, inflation is low, and unemployment is coming down.

Yet risks are clearly rising. From midterm elections to trade tensions and rising interest rates, a cloud of uncertainty has bogged down markets this year as investors wonder whether the best of the nine-year-old bull market is finally behind us. We offer three indicators that bear watching.

With the U.S. Federal Reserve looking to raise rates two more times this year, and the 10-year Treasury yield struggling to crack 3%, the yield curve is on pace to invert by year end. Even now, the spread between 10-year and 2-year Treasury yields has narrowed to a mere 27 basis points.² History suggests such an inversion would signal the beginning of the end for the equity bull market. In the past two market cycles, the S&P 500 Index peaked 6 months and 23 months, respectively, after the yield curve inverted. This timeline fits the consensus of our network, which believes that the next recession will likely begin in 2020.

When China’s currency devalued in short order in 2015, global markets had a fit. In fact, many believe that much of the market volatility we saw in early 2016 was the direct result of China’s slowing growth (represented in the country’s weakening currency). However, China poured on monetary and fiscal stimulus support in 2016, growth improved, and non-U.S. equities went on to outperform in 2017. The yuan has started to weaken again in 2018, and emerging-market equities are once again under pressure. China may enact policy measures to try to stave off a developing slowdown, but these actions may not be as forceful as those in 2015/2016, and they’ll take time to filter into the economy. We would not be surprised if China’s currency remains relatively weak in the back half of 2018.

A strong U.S. economy has held high-yield bond yields in a narrow trading range at low levels above U.S. Treasury yields of comparable maturities. In fact, recent tax cuts have helped push spreads to some of the lowest levels of this market cycle, as investors perceive more benign credit risk for below-investment-grade companies. If global growth stalls, this dynamic will likely change. Whether the catalyst is a trade war or central bank tightening, high-yield spreads could widen during the second half of 2018 as risks begin to surface—an early indicator that the U.S. economic picture has started to deteriorate. 

Taken together, these risk indicators suggest that risk management will be increasingly important going forward. In our Q3 Market Intelligence, we’ve maintained a modest bias toward equities—and to certain pockets of the U.S. equity market in particular—over the next 12 to 18 months, while downgrading our outlook for international equities to a neutral stance. Risk-conscious investors may see in today’s environment an opportunity to increase high-quality government bond allocations, but rising interest rates remain a threat to positive returns, particularly in the United States. Over the second half of 2018, we’ll continue to monitor these indicators to determine if a further reduction in risk is warranted.

1. FactSet, June 2018, based on EPS growth estimates of 20.04% for S&P 500 Index companies.    

2. U.S. Federal Reserve, as of July 11, 2018.