As the US equity market experienced the worst day of the year Wednesday 14th (August), the focus for financial market coverage was the inversion of the US curve. What does this actually mean? In layman’s terms basically in the US we are now at a point where two year yields are higher than ten year yields. The logic of this situation is tough to understand. It is hard to compute that you willreceive a higher rate lending money to the government for two years than for locking it up for ten. If that is tough to get your head around then understanding that logic that some major corporate paper is yielding negative rates and several countries are issuing bonds with negative rates – you’re paying them money to use your money! Why would you do that? Well the answer is that you think that they will go further negative and you will make money out of it.
The fear associated with the yield curve flattening you also continue to hear is – the curve inversion is the most reliable indicator for economic recessions and that equity markets being forward looking should rollover once the curve is inverted. That too seems an emotional response to a poor day of trade and the headlines need a little more explanation. The equity strategy team at Citibank clarify that curve inversion is an early indicator and recessions tend to occur 12-15months on average after the Treasury curve inverts. The key indicator in the past is not the flattening but when a rapid re-steepening occurs. The graph below going back to the eighties shows the economic cycles that have happened in the past.
The previous cycles show that the Federal reserve has reacted aggressively to counter GDP weakness with easing’s of monetary policy and those actions have not helped the decline in business activity. The steepening occurs as those aggressive monetary easing’s drive short end rates lower and the risk of future tightening’s shift out the curve pushing longer term rates higher. It is different this time, rates are already at record lows and in fact negative in Europe and Japan after significant quantitative easing efforts weren’t unwound and global government debt is at levels that the risk of future tightening cycles is not conceivable near term. After the recent easing the word used by Fed was that is was just an “insurance” on future growth.
Citibank is of the opinion that this is a mid-cycle slowdown following the Q2 earnings in the US and estimates were too high for 2019 and 2020 requiring a reset of both profit and equity market expectations. They are taking time to remind their clients that 75% of sales for the big cap index are North American based and about 10% are in non-cyclical international areas such as food, beverage, tobacco and pharmaceuticals so weakness in Europe or trade disputes should not be the main driver of US stock market performance. What the yield curve flattening has done has allowed the growth style investing to outperform particularly against financials as fund managers worry about the net interest margins of the banks. The other benefit of the collapse in bond yields is we are in a unique situation where dividend yields at the index level are higher than bond yields. Traditionally you received a smaller income from equities in exchange for the ownership in the future growth trajectory of that company. Currently as can be seen from the chart below that relationship with the bond market is inverted. The indicated yield on owning a SP500 ETF, commonly known as the SPYDER is 2% , in comparison US ten year bond offers you 1.58% , obviously the different asset classes sit differently in the capital structure when situations turn for the worse but the current point of focus is income.
Citibank forecast that the SP500 will end 2019 at 2850 which is the current level , but volatility is not to be unexpected. My conversations with Bond traders take a different tone. A bond manager from Macquarie told me that his expectations are that US treasuries are heading to Zero. A rather bearish view and a prediction of a very pronounced slow down. Mixed messages and suitably at Hudson Gore we are very cautious at present. We believe that there is considerable leverage in markets and acknowledge that while equities still remain attractive on some metrics the upcoming months are likely to see increased volatility. Perhaps time to take some profits and position a little more defensively….