U.S. cheese surplus sets record

milk and cheese

The average American consumed nearly 37 pounds of cheese in 2017, but it wasn’t enough to put a dent in the country’s 1.4 billion-pound cheese surplus, reports NPR.

Years of high milk production and declining consumer preference for processed cheese products have contributed to the cheese surplus, the largest in U.S. history.

“People are turning away from processed cheese,” said Andrew Novakovic, professor of agricultural economics at Cornell University. “We're seeing increased sales of more exotic, specialty, European-style cheeses. Some of those are made in the U.S., a lot of them aren't."

The surplus of American-made cheese and milk is pushing prices down, falling short of the break-even price of dairy farmers. Some analysts have expressed concern that U.S. trade tensions with China and Mexico could also negatively impact the dairy industry, although the impact of retaliatory tariffs on domestic dairy products has been relatively small. Source: NPR

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The average American consumed nearly 37 pounds of cheese in 2017, but it wasn’t enough to put a dent in the country’s 1.4 billion-pound cheese surplus, reports NPR.

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Benefitting from scrap

bundles of aluminum scrap

Companies in the U.S. that turn junked cars and beer cans into fresh aluminum are seeing a business boom thanks to the trade fight between the U.S. and China, reports the Wall Street Journal.

The Trump administration’s tariffs on foreign aluminum drove imports of the metal down 20% last year, while domestic production rose 20%. In fact, aluminum made from recycled scrap made up the majority of the aluminum used in the U.S. for the first time last year.

Pushing up U.S. aluminum production was the tariff’s intent. But domestic smelters that make new aluminum from bauxite aren’t able to supply more than a fraction of the aluminum consumed, even with higher production last year. Instead, much of the increase in domestic production to offset lower imports has come from the processors that make aluminum from scrap.

China also implemented more-stringent quality standards on U.S. scrap exports early last year that started to drive down exports, and then it followed with tariffs totaling 50% on U.S. scrap aluminum, creating a glut for U.S. recyclers to remelt into new aluminum. The U.S. generates more aluminum scrap than any other country. (Source: The Wall Street Journal)

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China still seeks growth while navigating new challenges

China’s markets were under tremendous pressure during the past year from fears of a slowing economy and the impact of a trade war with the U.S. The benchmark Shanghai SSE Composite Index fell by roughly 25% in 2018 and China’s bond markets and currency, the renminbi, also fell.

Ivy Global Economist Derek Hamilton traveled extensively through China to better understand the current situation, the views of policymakers and business leaders, as well as the potential policy response from China’s government. He found that concerns about the economy had increased. While policymakers expressed a more constructive tone and focused on protecting the downside, companies were concerned about falling demand.

Hamilton provides his analysis of the challenges China faces now and the potential responses from its leaders.

Limiting debt increase weakened economy

During the Global Financial Crisis, China decided to boost economic growth with a large increase in government debt. The increase in debt spread to the private sector, and corporate and household debt rose during the last decade. In 2017, policymakers in China decided to slow the increase in debt because of concern that total debt would reach an unsustainable level, especially when considering a rising debt burden in the face of a rapidly aging population. The screws were tightened throughout 2018, especially for shadow bank lending and local government borrowing. But this resulted in a dramatic slowdown in economic activity, especially in investment and consumer spending, during the first three quarters of the year.

In addition, the viability of the private sector was called into question, with some in China’s Communist Party wondering if the private sector would become too large at the expense of stateowned enterprises. Policymakers began to talk about less need for tightening in the middle of 2018 but didn’t really become concerned about the pace of the economic slowdown until the fourth quarter.

President Xi Jinping has come under mounting pressure to act. Citizens in China have shown they are willing to accept less personal freedom in exchange for improvements in their personal well-being. If the economy slows and unemployment rises rapidly, the people of China only have one party to blame.

Thus, the legitimacy of the Communist Party rests on a contented population. I believe the government is likely to become increasingly accommodative in a variety of areas in order to stabilize growth in gross domestic product and prevent a large increase in unemployment:

TAX CUTS

The central government cut personal income taxes in 2018. The next round of tax cuts is likely to focus on corporate taxes and value-added taxes.

INFRASTRUCTURE

I think infrastructure spending is likely to reaccelerate. Projects that were put on hold are being released. In addition, the central government is allowing local governments to issue debt at an accelerating pace to fund infrastructure projects. I believe these initiatives are likely to focus on environmental protection, water conservation, subway/railway expansion and rural development.

Bullet Train

China likely to pursue railway expansion

PROPERTY

During the last several years, China has tried to limit home price appreciation by dramatically increasing the cost of buying a home, upgrading a primary residence or buying a second home by imposing higher down payments and other onerous restrictions. Home sales began to weaken rapidly in late 2018. Weaker home sales can lead to less property development, and land sales for such development are a key source of revenue for local governments.

While taking steps to limit home price appreciation, China also supported demand for housing through a plan called shantytown redevelopment. Originally intended to demolish old units and rebuild new ones in their place, the plan was changed several years ago to deal with an oversupply of housing by introducing cash payments from the central government in order for families to buy new units. The government in recent months has been reverting to a process of giving units to families, rather than cash for individual purchases.

Sign in Shanghai with a farmer greeting
a city resident and the word Equality

China seeks to manage urban migration; sign in Shanghai with a farmer greeting a city resident and the word “Equality”

Given the importance of housing to the overall economy and to local-government revenues, I think local governments are likely to begin reducing down payments and removing some purchase restrictions. I have seen signs of this on a small scale since returning from China. If property markets weaken further, then the central government could mandate changes in these areas, which would be a more powerful and effective signal. In addition, I think the shantytown development program is likely to continue for the foreseeable future.

Chinese cities are typically classified in a tiered system based on population. It is worth noting that Tier 1 cities, which include five of the largest cities, continue to have an undersupply of housing. Inventories remain quite low in Beijing and Shanghai. There is a need in these cities for local governments to release more land for development. Policymakers continue to want migration from rural to urban areas, but they want those migrants to move to smaller cities. By contrast, many migrants want to move to Tier 1 cities. Given that urbanization will continue to be an important driver of economic growth, local governments are pushing urban residents to accept rural migrants into their communities.

Chart Showing economic growth has slowed from peak years

Headwind from U.S. - China trade war

The trade war between the U.S. and China has been a headwind for markets in both countries. Companies doing business in China, both domestic and foreign, are increasingly worried about the long-term implications of the trade war. Many are looking for opportunities to move production to other countries. This is putting further pressure on China’s policymakers to stimulate the domestic economy.

Several months ago, China thought it had struck a deal with the U.S. during negotiations with Treasury Secretary Steve Mnuchin, only to have the deal overturned by President Donald Trump. While this made China nervous about future negotiations, it appears that China is now willing to meet many of the U.S. trade demands.

For example, Chinese officials realize that something needs to be done about intellectual property (IP) violations – a key issue for the U.S. in the trade dispute – and recently released new rules to protect IP. However, it remains to be seen how well these rules will be enforced. It is in China’s interest to act soon, as domestic companies continue to innovate and are increasingly developing their own IP. Those companies will want to protect that IP, just as U.S. companies are seeking protections.

Starbucks Reserve Rostary

Increasing income shapes consumer preferences; Shanghai is home to the world’s largest Starbucks Reserve Roastery

Consumer culture continues to expand

Urbanization continues to increase in China. As more people migrate from rural to urban areas, income and productivity also increase. Per-capita income for urban residents in China continues to rise at a rapid clip, with the latest data showing an increase of nearly 8% in 2018. Rising disposable income brings a change in buying preferences, with more consumers choosing to spend on services or higher-quality goods versus basic necessities. Despite the slower economy, this trend was apparent when I was in China.

Chart Showing Urban population takes growing share

Credit availability has become a short-term headwind. Peer-topeer (P2P) lending exploded in China over the last few years and was a driver of consumption. Given the rapid development in such lending and the lack of regulation, the government’s concerns about rapid debt growth spread to the P2P industry. There have been many instances of P2P companies defaulting on loans, and individuals who depended upon financing now find it more difficult to get credit. While I believe P2P lending will continue to be constrained, the government is working to lower the cost of, and increase the availability of, credit for consumers.

Environmental issues come into focus

Environmental control has become a key focus of the central government. The term “Beautiful China” was included in the country’s 13th Five-Year Plan, introduced in late 2015. President Xi has made it clear that officials now must consider the environmental impact when making decisions. In other words, political careers are now judged on their impact on the environment as well as on economic growth.

Air pollution was the initial focus, with water pollution and soil contamination quickly following as a concern. The government has mandated shutdowns of heavy-polluting factories in the winter. Air pollution in Tangshan, China’s steel-producing capital, was better when I visited, but it still can be very bad at times in many cities, including Beijing.

Smog over Chinese city

Air quality is a growing issue in major cities

The government’s mandates on pollution are important for health reasons, but they are raising costs for companies. For example, the central government has mandated steel companies must move production outside the city limits of Tangshan. In addition, companies must transport all raw materials from ports via rail instead of truck by late 2020, which will require more rail lines to be built. This type of environmental crackdown in one city is being duplicated all over China.

China facing challenges ahead

China’s need to reduce the pace of debt accumulation must be balanced with the downside risks to the economy, which are coming from both domestic and external sources. China is likely to temporarily stimulate domestic demand, but doing so risks eroding progress made on the debt front. The country’s aging population will continue to lead to slower GDP growth. If China is unsuccessful in permanently slowing the pace of debt growth, then the aging population will make the debt load even more unsustainable.

Officials could strike a trade deal with the U.S., but longer-term pressures from the U.S. and other countries are likely to remain, especially as such countries try to slow China’s economic and military rise. I believe the Chinese economy will begin to recover in the second half of 2019, but the larger challenges will remain for an extended period.


Photo credits: Derek Hamilton

Past performance is not a guarantee of future results.

Investment return and principal value will fluctuate, and it is possible to lose money by investing. International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets. Fixed income securities are subject to interest rate risk and, as such, the net asset value of a fixed income security may fall as interest rates rise. Investing in below investment grade securities may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. Investing in the energy sector can be riskier than other types of investment activities because of a range of factors, including price fluctuation caused by real and perceived inflationary trends and political developments, and the cost assumed by energy companies in complying with environmental safety regulations. These and other risks are more fully described in a Fund’s prospectus.

The opinions expressed are those of Derek Hamilton and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through January 2019, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon.

The SSE Composite Index (also known as SSE Index) is an unmanaged index of all stocks traded on the Shanghai Stock Exchange. It is not possible to invest directly in an index.

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China was under tremendous pressure during the past year from fears of a slowing economy and the impact of the U.S. trade dispute. Global Economist Derek Hamilton traveled widely through China to understand the current situation, and analyzes the challenges and potential policy responses.

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- China is likely to focus on several key areas to stabilize growth and prevent a large rise in unemployment.
- Urbanization continues to increase in China; as more people migrate from rural to urban areas, income and productivity also increase.
- Credit availability has become a short-term headwind for companies and individual as China slows the rise in debt.

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Today’s trendsetters in technology and health care

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Technology and health care companies are changing the world through innovation. Our Ivy Live panel shared trends and ideas that caught their attention after attending CES and the J.P. Morgan Healthcare Conference, and what it all could mean for investors in 2019.

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Brad Warden, CFA
Portfolio Manager
Ivy Investment Management Company
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Gage Krieger, CFA
Assistant Portfolio Manager
Ivy Investment Management Company
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Charles John, CFA
Investment Analyst
Ivy Investment Management Company
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Technology and health care companies are changing the world through innovation. Our Ivy Live panel shared trends and ideas that caught their attention after attending CES and the J.P. Morgan Healthcare Conference, and what it all could mean for investors in 2019.

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The economic cost of the shutdown

The current government shutdown is now the longest in U.S. history, as President Donald Trump and congressional democrats remain at loggerheads over the security on the U.S. southern border. President Trump continues to push for $5.7 billion for a border wall, or barrier, between the U.S. and Mexico, while Sen. Chuck Schumer and House Speaker Nancy Pelosi are holding firm with a $1.6 billion proposal for border security enhancements, but no allocation for Trump’s much desired wall. Trump has threatened to declare a national emergency as a means of circumventing congressional approval to fund the wall, but hasn’t done so yet. While both sides remain at an impasse, the shutdown is beginning to have economic implications.

The current shutdown is defined as a “partial” shutdown, meaning 75% of the government remains funded, but 800,000 government workers have been furloughed without pay. Roughly half of these workers are considered essential and must continue to work without pay. During a shutdown, government workers do not receive paychecks if their departments have not received funding. (In early January, both the House and Senate passed bills to ensure affected workers receive back pay once the government reopens.) In addition, government procurement of goods and services is delayed for certain departments. Both of these issues have caused a slight drag on U.S. gross domestic product (GDP) growth.

Every week the government is closed, GDP growth on an annual basis is reduced by roughly 0.1 percentage points (pp), for a total of -0.4 pp at this point. The risk is that a much longer shutdown could start to impact GDP growth on a larger scale. Government workers could increasingly deplete their savings. A significant number of essential workers, such as TSA staff, could stop showing up for work, causing travel delays. Business confidence could be impacted as companies cannot receive government contracts. There is no sign of a significant impact yet, but we are watching closely.

Tax refunds are an important consideration during the shutdown. The acting director of the Office of Management and Budget stated that refunds will be issued, contrary to past shutdowns. However, what is less clear is the timing of these refunds. If nothing else, there is a risk that refunds will be delayed.

In addition, very few economic statistics produced by the U.S. government are being tabulated and released due to the shutdown. This makes it difficult to gauge the progression of economic growth, making it even more likely that the Federal Reserve is on hold for the foreseeable future. Even when the government opens, data will likely be choppy due to the shutdown, timing of tax refunds, and seasonal issues, which tend to lower GDP growth in the first quarter of each year.


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Past performance is no guarantee of future results. The opinions expressed are those of Ivy Investment Management Company and are not meant as investment advice or to predict or project the future performance of any investment product.. The opinions are current through January 2019, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon.

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Investable Theme: North American Shale

Shale oil still offers potential opportunities in many supporting companies.

Exploration and production companies grew rapidly after the onset of the “shale revolution” that boosted U.S. oil output. High-quality independent companies now are focused on increasing efficiency and reducing costs. Select shale producers have shown that they can be competitive on price with major oil exporting countries and grow profitably at current levels. They have continued to grow because of their efficiencies, productivity gains and strong balance sheets. North American shale companies have become the global swing producer in response to changes in supply and demand.


Source: U.S. Energy Information Administration

 

Investable Theme in Action: Ivy Energy Fund

David Ginther, CPA, and Michael Wolverton, CFA, portfolio managers of Ivy Energy Fund, believe that companies with access to the highest-quality drilling acreage and best technology stand to benefit at current oil prices.

A closer look at the Ivy Energy Fund

Consider these examples of stocks that we believe may benefit from development of North American shale.

Parsley Energy, Inc. (PE)

EOG Resources Inc. (EOG)

Pioneer Natural Resources Co. (PXD)


Past performance is not a guarantee of future results. The opinions expressed are those of the Fund’s portfolio manager and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through Dec. 31 2018, are subject to change based on market conditions or other factors, and no forecasts can be guaranteed. The holdings discussed are for illustrative purposes only and are not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy.

Investment return and principal value will fluctuate, and it is possible to lose money by investing.

PE: 3.12%, EOG: 4.15%, PXD: 4.10% of net assets as of 12/31/2018.

Risk factors: The value of the Fund’s shares will change and you could lose money on your investment. An investment in the Fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Investing in companies involved in one specified sector may be more risky and volatile than an investment with greater diversification. Investing in the energy sector can be riskier than other types of investment activities because of a range of factors, including price fluctuation caused by real and perceived inflationary trends and political developments, and the cost assumed by energy companies in complying with environmental safety regulations. These and other risks are more fully described in the Fund’s prospectus. Not all funds or fund classes may be offered at all broker/ dealers.

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David Ginther, CPA, and Michael Wolverton, CFA, portfolio managers of Ivy Energy Fund, believe that companies with access to the highest-quality drilling acreage and best technology stand to benefit as the price of oil recovers.

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Despite yield curve concerns, recession not on the horizon

Investors continue to closely watch the bond market yield curve’s “flat” profile that shows little difference between the yields on securities of varying maturities. Concerns over the curve escalated recently, as one section of the yield curve inverted for the first time in more than 10 years, with the yield on 5-year notes falling below 3-year notes. This has raised concerns over what it might mean for the markets and the U.S. economy. While an inverted yield curve has been a precursor to several past recessions, we do not believe a downturn in the U.S. economy is on the horizon.

Tight spreads, flat curve

The recent inversion occurred in only one part of the yield curve. Typically, the market’s focus on the yield curve generally refers to the difference in yields between the 2-year and 10-year U.S. Treasury notes. A “normal” yield curve has an upward slope, indicating higher yields for longer maturities. That higher yield compensates investors for the longer time commitment and associated risk.

The spread in yields has tightened in the past year based on several factors, including the expectation that the U.S. Federal Reserve (Fed) will steadily increase interest rates. For example, the spread on June 30, 2017, was 92 basis points (bps) as the 2-year note yielded 1.38% and the 10- year note yielded 2.30%. By the end of 2017, the spread had tightened — meaning a flatter yield curve — to 52 bps, with the 2-year at 1.89% and the 10-year at 2.41%. Fast forward to Dec. 4, 2018, when one part of the yield curve briefly inverted, the 2- and 10-year spread was only 11 bps, with the 2-year note at 2.80% and the 10-year at 2.91%.

The Fed has increased short-term rates nine times since 2015 as part of its current tightening cycle, bringing the fed funds rate to a target range of 2.25–2.50% at its December 2018 meeting. Markets generally expect the Fed will increase rates at least once in 2019, although recent volatility makes that less than a certainty. The yield on the 10-year note is much less affected by the actions of the Fed when compared with the 2-year, and tends to be more sensitive to investor concerns about gross domestic product growth, inflation, trade, regulations and taxes, to name a few key factors.

Yield curve much flatter than it was 10 years ago
Chart Showing Yield curve much flatter than it was 10 years ago

Past performance is not a guarantee of future results. Source: U.S. Treasury; yield curve chart on 12/31/2008 versus 12/31/2018; for illustrative purposes only.

The short end of the curve primarily is being affected by the Fed’s decision to bring the key fed funds rate to what it considers neutral, meaning it neither stimulates nor restrains economic growth. The long end of the curve is being affected by the “push” of increased Treasury supply from budget deficits, the Fed’s balance sheet normalization and an increased term premium versus the “pull” forces of global trade/growth concerns, a strong U.S. dollar, a global search for yield, political concerns and emerging market volatility. The pull factors currently outweigh the push factors, although we think that reflects a consequence of investors’ concerns about potential economic troubles ahead. Ideas of an inverted yield curve have added to those concerns because of the potential it would predict recession and the psychological affect that could lead to a market sell-off and hurt consumer confidence.

We believe the yield curve will stay flat for the foreseeable future, but we also must balance this with recent market volatility and the statement from Fed Chairman Jay Powell that current interest rates are “just below” neutral.

Yield curve as a predictive tool

Since 1981, there have been four U.S. recessions. An inversion of the yield curve has preceded them all. The past recessions began from six to 24 months after the inversion in the yield curve and averaged 17 months in duration.

Inversion of yield curve was harbinger of past U.S. recessions
Chart Showing Inversion of yield curve was harbinger of pas U.S. recessions

Source: Federal Reserve Bank of St. Louis; interest rate spread of two-year versus 10-year U.S. Treasury notes, shown in percent.

The yield curve did invert briefly during June-July 1998 before steepening again without a recession following closely. But another inversion in February 2000 preceded the 2001 recession.

An inversion in the 2-year/10-year Treasury spread thus appears to have been an effective predictor of recession. A flat yield curve, on the other hand, does not seem to have much predictive power. As an example, during the period Dec. 1, 1994, to Jan. 31, 2000, the average 2-year/10-year spread was 34 basis points and market returns remained healthy. Additionally, the inversion of the 3-year/5-year Treasury spread, similar to what we saw recently, has historically been poor at predicting recessions. According to Fundstrat, that portion of the yield curve has inverted 73 times since 1954, but only predicted a recession nine times.

While an inverted yield curve indicated future economic weakness, it has not called a top in equities. On average, equity markets peaked about seven months before the start of each recession and 10 months after the yield curve has inverted.

Inverted yield curve has not predicted equity market moves
Chart Showing Inverted yield curve has not predicted equity market moves

Past performance is not a guarantee of future results. Source: Federal Reserve Bank of St. Louis and Morningstar Inc. Period return refers to the time from the month of inversion to the month of equity cycle peak. All returns stated are as of the last day of the month noted.

Ivy view: Recession not on the horizon

The yield curve is flat and has been for some time. The U.S. economy has been in economic expansion mode for nearly 10 years, the second-longest expansion on record. Many feel we are in the later innings of this expansion, but corporate profits are not showing signs of weakening. While volatility has increased, we do not believe a downturn in the U.S. economy is on the horizon. The historic delay between an inversion and the start of a recession means there typically has been ample time to make portfolio adjustments if desired.


Different environment, same approach?


In this new environment, future Fed action might not look like the past. Check out this highlight from the recent Ivy Live to hear our take.

Get the full perspective


Past performance is not a guarantee of future results. The opinions expressed are those of Ivy Investment Management Company and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through December 2018, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon.

Risk factors: Investment return and principal value will fluctuate and it is possible to lose money by investing. Fixed-income securities are subject to interest rate risk and, as such, the value of fixed-income securities may fall as interest rates rise.

The Russell 1000 Index measures the performance of the large-cap segment of the U.S. equity universe. The Russell 2000 Index measures the performance of approximately 2,000 small-cap companies in the Russell 3000 Index, which is made up of 3,000 of the biggest U.S. stocks. It is not possible to invest directly in an index.

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There is concern about an inverted yield curve, which has been a precursor to several past recessions. But we do not believe a downturn is on the horizon.

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- The spread in yields has tightened in the past year based on several key market factors.
- We believe the yield curve will stay flat for the foreseeable future.
- We do not believe a downturn in the U.S. economy is on the horizon, despite the recent inversion.

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