Surveys of investors show a distinct degree of nervousness this summer. One reason may be President Donald Trump’s propensity for off-the-cuff Twitter activity, in which he took aim at Turkey, NATO and Iran, and global trade.
Another explanation is rather more technical – prosaic, even. But it also illustrates how caution about economic fundamentals is driving investor sentiment.
Economic growth looks strong in 2018. After all, the U.S. economy has expanded by 4% annualized in the second quarter. However, markets look to the future, rather than the immediate past.
What will growth look like in 2019 or 2020? Will it remain strong – or does a recession lie ahead? And how will companies prosper in a changing environment?
Economists’ models can help answer such questions. But leading indicators are also useful. One of the most heavily scrutinized leading indicators is the shape of the yield curve. The relationship between bonds maturing in two or five years, and in 10 or 30 years’ time, allows us to glean a fair amount of information about how investors see the world and what this means for styles of investing.
If growth is strong and inflation is picking up, the price of long-dated bonds should decline. This leads to higher 10- and 30-year yields and accordingly, the curve steepens. If a central bank responds to inflationary pressures by raising short-term interest rates, the curve flattens.
In extreme circumstances, economic growth starts to roll over until recession appears, and the yield curve inverts. That is, short-term yields are higher than long term yields.
Good in parts
How valuable is the yield curve as a leading indicator? The results vary from country to country. In Australia, for example, the yield curve has recently been inverted several times, but there has only been one recession, back in the early 1990s.
Elsewhere, the Bank of Japan’s (BOJ) monetary policy is to control the whole yield curve out past 10 years, while the German yield curve reflects not only the German economy but also safe haven aspects within the wider Eurozone economy.
For these reasons, such yield curves tend not to have as much information content.
But in the U.S. – the world’s most powerful economy - the shape of the yield curve has proven far more useful as a leading indicator.
But in the U.S. – the world’s most powerful economy – the shape of the yield curve has proven far more useful as a leading indicator. One reason appears to be that the gap between short and long rates particularly affects the corporate bond market, a more important driver of the U.S. than other economies.
What has been happening recently? As the U.S. Federal Reserve (Fed) has steadily raised interest rates since 2016, the yield curve from two to 10 years has flattened, with the differential reducing from more than 2.5% to less than 0.3%. This is the narrowest gap since 2007. U.S. benchmark bond yields have indeed moved higher, reflecting a slow deterioration in inflation and the recent big fiscal boost from President Trump, courtesy of his tax reforms.
There is a world of difference between a flat yield curve and an inverted one.
In the past 40 years, there have been only four instances of major U.S. yield-curve inversion, namely August 1978, January 1989, February 2000 and December 2005. Each one of these events was followed by a period of economic recession.
That said, the lag between inversion and recession is variable and can be significant – varying from one to almost three years. Nor is the indicator 100% reliable. There can be false signals, as was the case in 1997, although it should be said that these are few and far between.
When the yield curve inverts – and stays inverted – this results in a poor performance for the U.S. stock market or even global equities. The average decline has been more than 30% for the S&P 500 index over an 18-month period.
During such periods, investors adopt a defensive posture, be that holding cash, high quality investment grade debt and government bonds, or dividend-paying stocks with strong balance sheets.
At such a stage of the investment cycle, cyclical and financial sectors do not perform well.
Currently, messages are mixed. Neither the global nor the U.S. yield curve is currently inverted, and a flat yield curve is very common in the final growth phase of the investment cycle, one where company profits are strong.
There are some aspects of the labor markets in the U.S. and Europe, which are flashing amber warning lights to investors, as low unemployment leads to some pressures on wages and hence company margins.
But against that, other leading indicators such as business investment, credit availability or the state of the housing market continue to suggest healthy U.S. and European business cycles.
Historically, a peak in company profits growth, as we are probably seeing in the first half of 2018, is usually followed by several years of robust stock market expansion before the final downturn. For example, 1994-2000 was a long period of a flat yield curve, during which period both the economy and stock marker prospered.
The shape of the yield curve is indeed important, as are the messages we can glean from it. Some central bankers warn that the yield curve is signaling that policy is about to become restrictive. There is indeed a risk that the Fed makes a policy mistake if it hikes aggressively into next year and the U.S. dollar appreciates sharply.
However, we would only become wary on the outlook for global equities if other leading indicators – such as widening corporate bond spreads - combine with a noticeably inverted yield curve to suggest that a recession is indeed looming.
Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).
Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.