The Fed joined other major central banks in easing conditions. While officials want to avoid getting into “catch-up” mode, the Federal Open Markets Committee is divided as officials weigh their desire to head off a downturn against fears of using too much dry powder while the economy is broadly in line with their mandate. The market is skeptical, pricing 3-4 rate cuts in the coming year. Investors are increasingly concerned that the Fed’s toolkit won’t be sufficient when the cycle finally turns. The yield curve has remained inverted since the middle of May, and the 30-year government bond rate reached an all-time low in August. Poor liquidity in overnight funding markets added to the anxiety as the Fed was caught flat-footed by tight funding conditions. We expect a lot more discussion about the effectiveness of policy tools in the coming quarters. Debate about the merits of fiscal stimulus vs. quantitative easing, negative interest rates, and yield curve targeting will keep market participants on their toes. Rhetoric going into the election next year is likely to heighten risk.

It has been a banner year for most asset classes so far in 2019, but a closer look reveals troubling signs. Strong equity returns are mostly a recovery from last year’s dismal performance. While the total return on the S&P 500® was over 20 percent year-to-date as of the end of the third quarter, since last September, 2018, the index has returned just over 4 percent. Despite touching a new record in late July, market leadership has moved to more defensive sectors, and continued momentum has been elusive. High grade corporates and high yield bonds produced year-to-date total returns of 13.20 percent and 11.41 percent, respectively on spreads that were flat to tighter. Long treasuries returned almost 25 percent over the last 12 months as investors sought refuge in government bonds. Such returns are more typical of “risk-off” periods. Underneath the veneer, markets are showing signs that investors lack confidence in the direction of the economy.

Despite easier monetary policy and solid performance across most asset classes, investors seem to be more focused on negatives. Sentiment is uninspired on slowing growth, earnings pressure and event risk. Market volatility in both interest rates and stocks continues to trend upwards as investors remain unconvinced that the Fed’s actions to date are enough to accelerate growth. Market participants are worried that the policy toolkit will be insufficient when the next downturn occurs. We expect the margin of safety to edge down as the expansion ages, increasing volatility. Given mixed economic signals and an assist from the Fed, it’s not clear that markets will go down from here.  Nonetheless, we are more tempered in our risk taking.