Uncertainty returned to markets this week after the US Treasury yield curve inverted, a notorious harbinger of recessions since the second world war.
Rising concerns that monetary policy, trade talks and slowing global growth could choke US economic growth have the markets attention. Yet there’s no need for investors to panic, as policy makers have more levers than ever before to navigate the US slipping into a recession. Knee jerk reactions could also mean investors miss out on the rally that usually follows a yield curve inversion.
What should you be doing?
Seeing the impact of this uncertainty in your portfolio can be uncomfortable and it’s understandable that you’ll want to protect the value of your investments from these fluctuations.
However, reactively trading to limit losses can do more harm than good over the long-term, and it’s important to remember that you only cement the loss in your portfolio when you press disinvest.
Typically, markets rally 15% in the 18 months following an inversion, research from Credit Suisse shows. If you’d have sold during the uncertainty of the last five yield inversions, you’d have missed out on this rally.
It’s difficult to time markets in the short-term. If you do try you need to be right twice – you need to sell at the right time and buy back at the right time. Everyone focuses on the first, but they’re both equally important when you compare to someone who focuses on the long-term and remains invested during short-term fluctuations.
These are notoriously difficult decisions to get right. If you get it wrong and miss the rebound that often happens after bouts of volatility, this can have a significant impact on the value of your portfolio over time.
For example, if you’d have invested $10,000 on 1 January 1998 and left it tracking the S&P 500 until 29 December 2017, your portfolio would have been worth $40,135, more-than double the $20,030 you would have if you missed just the best 10 days in the market. Miss a month of the best days and the value of your initial $10,000 would have slipped -0.91% to $8,331.
The JP Morgan research shows that the best days often occur within two weeks of the 10 worst days of the market, which should help investors gain confidence to ride fluctuations depending on their time horizon.
What’s happened?
Bond markets have been sending investors messages to those that have been listening of late, warning that a recession could be looming. It’s done this through falling bond yields, which have changed the shape of the US yield curve.
Falling far and fast, the yield on the US 30-year Treasury fell below 2% to 1.98% for the first time ever (apparently) this week, sliding from 3.4% in November 2018.
The US government sells debt with ‘maturities’ ranging from 1 month (bills) to 30-years (bonds). Under normal circumstances, you’d expect the yield (return) to be higher for bonds with longer maturities to compensate for the erosion of inflation and the higher risk that the government may default on its debt during longer time periods.
Put this on a graph and you’ll see a ‘yield curve’ that slopes upwards, as the yield increases in tandem with the maturity of the debt.
Yet when growth expectations weaken, there may be an inversion of the curve as long-term yields fall below their short-term siblings.
In a nutshell, a sustained inverted yield curve usually means a recession is on the horizon. This is what has upset global equity markets this week as the difference between the US 10-year and 2-year bond rates slumped to around zero before temporarily inverting.
Whilst this was a temporary inversion and not sustained, markets are now watching keenly.
‘This time it’s different’
Now, lots of people have gone through various mental gymnastics to explain why this time is different.
There are lots of uncertainties. First, the US yield curve hasn’t sustainably inverted yet, and it may not. After all, the US economy isn’t that weak.
In the US and the UK, inflation is close to the 2% target. In the case of the US, it’s certainly closer to the target than President Trump would like (which might be why he’s delayed some of those new tariffs until after Christmas).
There’s a policy dimension here too – if Central Banks start talking about a new approach to inflation-targeting using averages, which would be good for equity markets.
Second, Central Banks are likely to move much faster than maybe they did in past recessions. As long-term yields are influenced by interest rates as well as the economic outlook, a sustained inversion is a strong indication that the market thinks monetary policy is set to choke economic growth. A recession could force the Fed to cut rates again, which will boost bond prices.
Markets are certainly expecting the Fed to climb down further, and they will do what they can to make that a reality.
Then there’s the US election cycle. President Trump can blame the Fed all he likes, but the impact of trade policy on sentiment is tough to ignore. Even if he believes the US will outlast China in the long-term – what he really cares about is how we can stimulate markets and the economy between now and November 2020.
Trade tensions weighing on growth expectations
Earlier in August, the White House slapped further 10% tariffs on $300 billion of additional Chinese imports, triggering uncertainty on equity markets and increasing concern over global economic growth.
China has vowed to retaliate, despite the US delaying over half of the tariffs until after the Christmas season to protect consumers from higher prices.
It looked like an end to the trade spat was close in May, before US negotiators abruptly cancelled talks in relation to intellectual property disagreements. Tariffs escalated soon after, before a June summit between US President Donald Trump and his Chinese counterpart Xi Jinping eased tensions once again. This was also short-lived, however, as the US accused China of failing to keep to its side of the armistice.
Trump’s previous rhetoric has softened over recent days as he insisted the trade war would be short-lived. However, he’s under increasing pressure to take a tougher stance on Beijing to prevent a crackdown by the state on anti-government protests in Hong Kong.
What does this all mean for your portfolio?
We’re expecting a bumpy road ahead in the short-term, with only the US showing some resilience (outside of labour markets) in a weaker global economy.
When managing your portfolio over the next few months, our Investment Team will be monitoring the bond markets, macroeconomic data, and policy response from monetary, fiscal and trade policymakers.
As for positioning, on days like these you’d always rather have less equity exposure. But the Investment Team would have thought that in late December and we’d have suffered for it.
Today, the Investment Team are pleased that we chose to manage risk by reducing the equity exposure in our portfolios in our last two rebalances (March and October), although are still positioned to make the most of global opportunities as the arise. The team are happy with how our portfolios are positioned for the long-term risk profiles of our investors.
Our Investment Consultants are here to talk you through every part of your investment journey. If you have any questions about the decision-making of our Investment Team or the advice you have been given, please get in touch with the team on 0800 4334574. Technology makes our advice cost-efficient, our Investment Consultants make our advisory service work for you.
