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Stocks Plunge as Bond Market Sends Recession Warning Signal

Stocks plunged Wednesday after Treasury markets sent a fresh recession signal following reports of weak German and Chinese economic data. The S&P 500® index lost 2.9% in one of its worst days of 2019. Meanwhile, the 30-year Treasury bond yield ended the day at 2.03% after falling to a record low.

The yield on the 10-year Treasury bond dipped below the two-year Treasury yield for the first time since 2007. A yield curve “inversion” such as this has often—although not always—signaled that a recession is likely within the next 12 to 18 months.

“The decline in yields is being led by the long end of the curve, largely reflecting the slowdown in global economic growth,” says Kathy Jones, Chief Fixed Income Strategist at the Schwab Center for Financial Research.

Fears of a global economic slowdown rose after Germany reported that its economy contracted in the second quarter—its economy is believed to be contracting in the current quarter, as well, raising concerns that the country is moving into recession. Meanwhile, Chinese industrial production fell to its slowest pace in 17 years, according to government data, pointing to a sharp slowdown due to tariffs imposed by the United States in a long-running trade dispute between the two countries.

Wednesday’s stock drop erased market gains made Tuesday, when investors reacted enthusiastically to an announcement by the White House that it would delay imposing 10% tariffs on certain Chinese goods until December.

“Although tariffs on a broad array of consumer goods have been postponed, they haven’t gone away. Consequently, the uncertainty will likely weigh on business confidence, keeping investment low,” Kathy says. “With global bond yields low or negative, U.S. yields are being pulled lower as investors seek some sort of positive yield.”

The Fed is likely to cut rates again

The Federal Reserve cut short-term interest rates by 25 basis points at its July policymaking meeting, and markets expect that more Fed rate cuts are coming.

“The expectation is that the Fed will need to cut rates to offset the impact to the United States of a slowdown in the global economy,” Kathy says. “The market is already pricing in several rate cuts over the next year.”

Bonds are often viewed as a safe-haven investment in times of uncertainty. Bond yields move inversely to bond prices, so yields are driven lower as investors flock to the bond market.

“Yields have fallen a lot and are below what we would consider ‘fair value,’” Kathy says. “For example, absent the global pressures, 10-year Treasury yields would likely be trading slightly above 2%, compared to the current yield of about 1.60% … That being said, the divergence could continue and grow wider.”

What could change the situation?

An announcement of a comprehensive U.S.-China trade deal that would end tariffs would likely have a big positive effect on the market, Kathy says. The U.S. and China have gradually ratcheted up pressure on each other in a year-long trade dispute that is already weighing on global manufacturing activity.

Markets also likely would welcome some indication that countries with the capacity to use fiscal stimulus, such as Germany, are planning to cut taxes, boost spending or take some other measures to lift their economy, Kathy says.

What investors can consider now

Fixed income investors should consider the following steps.

  • Despite low yields, high-quality fixed income securities can help diversify equity risk. “Times like this illustrate why it’s helpful to have some high-quality fixed income as a part of a diversified portfolio,” Kathy says. U.S. Treasury securities historically have provided the best hedge against equity market declines, and investors should consider owning some intermediate- or longer-term bonds to lock in yields now in case they fall further.
  • Bond “barbells” and “ladders” can help to spread duration risk.
    • A bond barbell is a strategy in which you buy short-term and long-term fixed income securities—with nothing in between, it resembles a barbell. Consider high-quality securities maturing in three years or less for the short-term holdings, paired with maturities in the five- to 10-year area. A barbell has two key benefits: it allows you to lock in longer-term yields, in case yields fall further. Meanwhile, the short-term investments provide liquidity and relative price stability.
    • A bond ladder is a portfolio of individual bonds with staggered, or “laddered,” maturities. It is an all-weather strategy meant to help provide predictable income with the flexibility to reinvest bonds as they mature, instead of being locked into a single interest rate: When a bond matures, you can reinvest in a new longer-term bond at the end of the ladder. If bond yields have risen, you will benefit from a new, higher interest rate—but if yields have fallen, you will still have higher-yielding older bonds in your ladder.
  • Focus on higher-credit-quality bonds. If the U.S. is heading toward recession—as the inverted yield curve seems to imply—then low-credit-quality bonds, such as high-yield corporate bonds or emerging market bonds, are likely to underperform, Kathy says.
     

For more active equity investors consider the following.

  • Financials are the most exposed to an inverted yield curve, as banks earn net interest income by borrowing at short-term rates and lending at longer-term rates. The information technology sector is the most exposed to tariffs on Chinese imports. Other cyclical sectors—that is, sectors and industries that are particularly sensitive to economic fluctuations—could be hurt as well.
  • Stocks most exposed to trade with China have underperformed during the past three weeks, suggesting the market is growing pessimistic about a U.S.-China trade deal.
  • We continue to favor U.S. large-cap over small-cap stocks. Small caps tend to underperform later in the business cycle, are less nimble with regard to tariffs, and have higher debt ratios than large caps.
     

For longer-term investors we suggest that you rebalance your portfolio as well as making sure your portfolio’s asset allocation matches your risk tolerance. Market changes can skew your overall portfolio allocation from its original target. Over time, assets that have gained in value—such as stocks—will account for more of your portfolio, while those that have declined will account for less. Rebalancing means selling positions that have become overweight in relation to the rest of your portfolio, and investing in positions that have become underweight. Meanwhile, if recent market action has made you realize you’re not comfortable with your risk level, it may be prudent to dial back the overall risk in your portfolio. However, keep in mind that it’s important to take into account both short- and long-term goals—for money that you won’t need for a long time, it’s generally best to stick to your long-term plan and remain invested.

Bottom line

Market drops are an unavoidable feature of investing. What matters is how you respond—or, more to the point, don’t respond. Sometimes the best action to take is no action at all. If you’ve built a portfolio that matches your time horizon and risk tolerance when markets are calm, then a surge in turbulence may not feel so rough to you.

However, if you’re looking for something specific to do now, check out some steps that every investor should consider. Or watch Charles Schwab, Chairman of the Board and Founder of Charles Schwab & Co., discuss his approach to market volatility.

What if you’re near retirement, or have a short investing horizon? Here are some things to consider if you don’t have much time to recover from market volatility.

What You Can Do Next

  • Focus on the long-term. If you’ve built a solid financial plan and a well-diversified portfolio, it’s best to ignore the noise and focus on your long-term goals. Get additional guidance from Schwab’s experts on strategies for weathering market volatility.
  • Talk to us. Schwab is happy to discuss your portfolio whenever and wherever it’s convenient for you.  Call us at 800-355-2162visit a branch or find a consultant.
  • If you need a plan, consider Schwab Intelligent Portfolios Premium™. You’ll have access to a Certified Financial PlannerTM professional who will collaborate with you to develop a financial plan tailored to your goals.
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Important Disclosures

The information provided here is for general informational purposes only and should not be considered an individualized recommendation or personalized investment advice. The investment strategies mentioned here may not be suitable for everyone. Each investor needs to review an investment strategy for his or her own particular situation before making any investment decision.

All expressions of opinion are subject to change without notice in reaction to shifting market or economic conditions. Data contained herein from third party providers is obtained from what are considered reliable sources. However, its accuracy, completeness or reliability cannot be guaranteed.

Please read the Schwab Intelligent Portfolios Solutions™ disclosure brochures for important information, pricing, and disclosures related to the Schwab Intelligent Portfolios and Schwab Intelligent Portfolios Premium programs.

Schwab Intelligent Portfolios® and Schwab Intelligent Portfolios Premium™ are made available through Charles Schwab & Co. Inc. ("Schwab"), a dually registered investment advisor and broker-dealer. Portfolio management services are provided by Charles Schwab Investment Advisory, Inc. ("CSIA"). Schwab and CSIA are subsidiaries of The Charles Schwab Corporation.

Past performance is no guarantee of future results and the opinions presented cannot be viewed as an indicator of future performance.

Investing involves risk including loss of principal.

Indexes are unmanaged, do not incur management fees, costs and expenses, and cannot be invested in directly.

Diversification and rebalancing strategies do not ensure a profit and do not protect against losses in declining markets. Rebalancing may cause investors to incur transaction costs and, when rebalancing a non-retirement account, taxable events may be created that may affect your tax liability.

Fixed income securities are subject to increased loss of principal during periods of rising interest rates. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower rated securities are subject to greater credit risk, default risk, and liquidity risk.

A bond ladder, depending on the types and amount of securities within the ladder, may not ensure adequate diversification of your investment portfolio. This potential lack of diversification may result in heightened volatility of the value of your portfolio. You must perform your own evaluation of whether a bond ladder and the securities held within it are consistent with your investment objective, risk tolerance and financial circumstances.

The S&P 500 Index is a market-capitalization weighted index that consists of 500 widely traded stocks chosen for market size, liquidity, and industry group representation.

The Dow Jones Industrial Average is an index that tracks 30 large, public companies trading on the New York Stock Exchange and the Nasdaq.

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