Curve Inversions: The Perfect Catalyst?
After a tumultuous week of trade tensions, currency moves and Brexit uncertainty, markets declined significantly yesterday after a key technical level was breeched in bond markets, signalling a high probability that a recession lies ahead. As a result, risk-off sentiment has been spreading through financial markets, suggesting this could be the catalyst we have been waiting for.
Yesterday, the US 10-2 year treasury yield curve inverted, sending a strong warning that the US economy may be headed for recession. Inversion of the yield curve happens when the interest rates on short term bonds are higher than the rates paid by long term bonds, meaning that investors are so worried about the near term outlook that they are piling into the longer term, safer investments. In normal markets, investors demand to be paid more (via a higher yield) for locking up their capital for the long term, than they do for the short term, to compensate for higher risks over a longer time period such as inflation and other uncertainties. For US government bonds, that relationship has now turned upside down. The yield curve has inverted before every US recession since 1955, therefore is regarded as a strong indicator that a downturn is on the way.
The 2-year/10-year yield curve (1980-present)
The graph shows how each time the curve has inverted, this has been followed by a recession in the following months or years.
Bond markets over the course of the year have gained momentum as risk-on sentiment began to wane as a result of stretched equity valuations and weaker economic data. Bond markets first sent warning signals earlier in the year in Q1 2019 as the 10-year and 3-month treasury yield curve inverted as central banks became more dovish on the outlook. Since then, the economic back drop deteriorated further, resulting in increasing demand for risk-off assets, leading to the inversion of both the UK 10year/2-year gilt and US 10-year/2-year treasury yield curve yesterday, as recession fears exacerbate globally.
Why now? Negative economic data was the key catalyst for the yield curve inversion as the Eurozone’s experienced another week of bleak economic data, as its largest economy Germany reported a contraction in GDP by 0.1% in Q2, and as industrial output fell to a 6 year low in China, indicating that risks are skewed heavily towards the downside.
For more information on the challenges facing European markets, please see the attached Market Update document
Additionally, following optimism on Tuesday, on Wednesday it became clear that President Trump’s decision to delay some of his new tariffs on Chinese goods from September to December was due to pressure from corporates in the lead up to the Christmas trading period, rather than progress made in trade negotiations, downgrading expectations for a trade deal before the end of the year.
Financial markets were in a state of frenzy as investors fled from riskier assets, as risk-off sentiment spread across equity markets. The influx into bonds pushed world’s stockpile of negative-yielding bonds to another record as the Bloomberg Barclays Global Negative Yielding Debt Index closed at $16 trillion as investors fled to bonds as a flight to safety, pushing down long term rates.
What are the chances of recession?
The curve inversion is flagging a 60% chance of a US economic recession in the next 12 months. Although a recession is not imminent, the inversion is expected to prompt an equity-market sell off as investors are now more risk-off, potentially confirming our expectations for a near term decline in equity markets.
What does this mean for my portfolio?
Inversion of the curve typically proceeds a recession, signalling a negative outlook for risk-on assets, therefore our expectation is that equity markets will fall on this news, and could trigger the sell off we have been waiting for. Given our current defensive positioning, the portfolio benefits from a decline in markets, with low traditional equity exposure, shorts which benefit when markets fall, and high exposure to risk-off assets such as bonds and property.
Key events this week:
• Today: US Retail Sales for July
• Friday: US Consumer Sentiment for August
For anyone who wants further data to substantiate the position please review the attached Global Economic News Document attached.
Model Portfolios & Indices
Over the week, global equity markets declined as downside risks increased, escalated by the inversion of the US and UK yield curve yesterday, stoking recessionary concerns among investors. Safe haven assets such as gold gained alongside bonds, as risk-off sentiment continues to spread within financial markets. After equity markets rose on Tuesday on President Trump’s announcement to delay some of the new tariffs on Chinese goods, gains were eroded as it became clear that the delay was not relating to progress in talks with China, but rather a reaction to pressure from US companies which would be effected in the all-important Christmas trading period. It is clear that geopolitical tensions remain, and economic data continues to illustrate weakness in the global economy, with risks now tilted towards the downside. As the OBI portfolios remain defensively positioned with limited equity exposure and a downward tilt which seeks to benefit when equities decline, our portfolios gained over the week, with the defensive barbell within portfolios performing well. It is key to also highlight that performance from yesterday has not yet fed through into the benchmark and portfolio performance shown in the table from our research tool, therefore we expect the benchmark to have declined further this week and our portfolios to have gained by more over the period.
As we progress from here, it is important to recognise that we should not let benchmark performance make us feel like we have missed out on anything, because although we have in the short term, recent performance shows how quickly this can be reversed given current levels of risk and uncertainty.
Overall, it is our view that markets will continue to fall before adjusting to the new norm based on lower global growth and weaker corporate profitability. The key point here is to take a long-term view, look at the current level of uncertainty in the global economy, and remember that the portfolio is designed to minimise your exposure to risk and preserve capital. As shown in recent weeks, the capital preservation strategy is designed to remain flat when equity markets display volatility, with a defensive tilt which means that when markets do decline, the portfolios are well positioned to benefit. Markets
are behaving irrationally, therefore the most sensible strategy is a defensive one given current market conditions.
Important Information
The data above will not directly correlate to the indices as there is always a delay in pricing because the US markets close significantly later than the European markets and the Asian markets. The data set above reflects the last close and much of the days movements will not yet be reflected in the portfolios due to pricing delays. You cannot therefore directly correlate indices to the portfolios. The value of investments may fluctuate in price or value and you may get back less than the amount originally invested.
Past performance is not a guarantee of future performance. Performance figures quoted include the fund manager charges but exclude other fees such as adviser, custodian, switch and/or discretionary investment management fees. Unless otherwise instructed and accrued, income is reinvested into the portfolio.
This Day in History
On this day in 1945, Japan surrendered unconditionally to end World War II. President Harry Truman declared the day as Victory over Japan Day, as the Japanese Government had agreed to comply in full with the Potsdam Declaration. The end of the war was marked by a two-day holiday in the UK. Historic buildings all over London were floodlit and people crowded onto the streets of every town and city shouting, singing, dancing, lighting bonfires and letting off fireworks.
Have a great week!
Jason & Gina
