August 18, 2019 – Last week was another incredibly volatile period for financial markets, with trade tensions, mixed economic data, and an inverted yield curve contributing to wild swings in stock and bond markets. While the recession risks have risen, it is still not our base case that the U.S. will enter recession or experience negative government interest rates prior to next year’s election. We are urging clients to remain patient and not overreact to the volatility (to hear more about how volatility is a normal part of investing, listen to our recent podcast, “Stock Market Swings”).
An inverted yield curve is one of those financial market indicators that strikes fear into the hearts of investors, and for good reason. The Treasury yield curve has inverted—where the yield on short-maturity Treasury bonds exceeds that of long-dated Treasuries—as it has prior to each of the last five U.S. recessions. The portion of the curve between the 10-year and 3-month yields inverted for the first time in this expansion back in May, but the 10-year minus 2-year slope is regarded by many as a more reliable recessionary indicator, and that remained upwardly sloping—until August 14. Cue the market hysteria.
While investors seemed to hit the panic button immediately after the inversion, we wanted to provide a bit of context to put the market developments in perspective.
- First, while an inversion has in the past successfully predicted a coming recession, the lag from inversion to recession has varied greatly, and so inversion in itself has been a lousy timing tool. Historically, the yield curve inverted anywhere from 7 to 27 months before the market peak, with as much as an additional 7 months—almost 3 years in total—before the onset of a recession (Figure 1). These inversions were also generally sustained for a period of weeks, if not months (with the exception of 1998, which also happened to be the only time the yield curve inverted and was not followed by a recession). Last week’s inversion was a very brief intraday dip—barely enough time to eat lunch—into negative territory. Said another way, the yield curve inversion last week told us what we already knew, that the U.S. economy is late cycle.
- It is key to look beyond the mere fact of inversion to the underlying causes. In the past, the yield curve inverted because the Federal Reserve was raising rates to cool inflationary pressures, pulling up the short end of the curve above the long end. That is different than what we witnessed this past week, when the yield curve inverted because longer maturity yields fell faster than shorter-dated maturity yields. This occurred due to the disinflation being experienced globally, along with fresh headwinds that markets see in the latest escalation in the U.S.–China trade war. Pinpointing the cause is critical since it tells us, unlike with past inversions, we don’t have a Fed fighting inflation and economic growth. Rather, the Fed has clearly signaled a bias toward more supportive policy, and while the number of rate cuts from the Fed over the next year is debatable, the chance of a hike over that timeframe is slim. An inversion in a time when the Fed is already easing greatly reduces the risk of a near-term recession.
- The inversion also takes on a different context in light of economic activity outside of the U.S. Global financial markets are much more globally integrated than the U.S. economy, which remains fairly “closed.” There is currently more than $13 trillion in negative-yielding investment-grade bonds globally, which represents 43% of the ex-U.S. market. As crazy as it may seem, the U.S. 10-year Treasury yield of 1.5% looks attractive to yield-seeking investors, which has increased demand for U.S. debt and driven down yields. Therefore, the 10-year Treasury is saying more about global disinflation and relative yield differentials than it is about the intrinsic state of the U.S. economy. And of particular note regarding the letter, recent data have shown the U.S. consumer to be broadly unfazed by trade developments, continuing to both borrow and spend at healthy levels.
- It also bears mentioning that August has historically been one of the weaker months for the stock market, in part because of heavy vacation calendars and low market liquidity. We also add to that the rise of algorithmic trading, which likely triggered a wave of “sell” orders following the inversion and subsequent rounds of selling to cover positions or meet margin requirements for leveraged accounts. Expecting higher volatility over the next few weeks would be a reasonable assumption.
Figure 1: Yield curve is a poor timing tool
All of this is to say that we recognize the signal the inverted yield curve has given us, and we are wary of joining the “this-time-is-different” crowd. However, when we look at the collective picture, we find ourselves in a similar spot to where we were a few weeks ago: late cycle with mounting risks related to trade but no expectation of an imminent recession.
Fundamental analysis aside, we also believe that the Trump administration would be motivated to provide some tariff relief if the overall economy decelerates sharply into the 2020 presidential election. We reduced our equity exposure from an overweight to neutral and increased our exposure to high-quality fixed income back in May in anticipation of the rising trade risks and higher volatility playing out in the market today. We have also taken a more defensive tact within equity portfolios, seeking lower- volatility stocks and higher-quality balance sheets, i.e., those we believe offer high return on equity, high free cash flow, and low leverage (for more on this, see the recent Op Ed on CNBC.com). These moves have all worked quite well in our portfolios during the recent volatility bout.
As the economic and policy risks shift, we will continue to adjust portfolios to protect clients and take advantage of investment opportunities when they arise. But for now, steady as she goes.
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