Two signals flashed last week that sent markets into a sharp freefall and increased the fears of a global economic slowdown; they were an ‘inverted yield curve’ and ‘negative interest rates’.
The first one occurs with some regularity, usually at the end of a business cycle. The second one is highly abnormal and suggests that our monetary system is moving deeper into uncharted and dangerous waters. Should we be concerned? Let’s take a brief look at both of them.
Inverted yield curve
Normally, you would expect to receive a higher rate of interest for money that you tie up for a longer term than money you tie up for a short term. There is an accepted theory behind it called ‘time preference’ that explains interest rates and people’s preference to spend in the present over the future, therefore they have to be encouraged to invest for a longer term. As there is more uncertainty when investing for a longer term, investors are rewarded with a higher interest rate.
This difference between long-term and short-term rates can be expressed on a graph as a line and usually it slopes upward from left to right, with time on the horizontal axis and the rate on the vertical axis. This line is called the ‘Treasury Curve’. From time to time, during periods of increasing economic anxiety, this line can flatten which means that there is no difference between the rates obtained for investing for a longer term over a shorter term. People become concerned with the outlook for the economy and don’t want to tie their money up due to the uncertainty with what the future holds.
Last week, the US Treasury Curve on the spread between the 2-year and 10-year Bond inverted, which means short-dated rates became higher than long-dated rates. It caused a panic in global stockmarkets. The reason for the panic is simple. On every occasion since 1945 when the curve has inverted it has accurately signalled a recession.
The question is; will it happen this time?
First, it needs to be pointed out that the ‘yield curve inversion’ is only a signal. It doesn’t forecast a recession. It reflects anticipated lower rates due to economic weakness. Furthermore, the recession always happens with a lag, which means there is time for the Federal Reserve to act.
Negative interest rates
The second ‘warning’ signal came with a very abnormal move on the Bond rates themselves.
Bonds are issued by Governments when they want to borrow money. They are generally considered to be a low risk investment as they offer a guaranteed interest payment with security of capital. Historically, Bonds issued by Governments of developed economies would have a ‘yield’ of 5-6% per annum on average for a 10 year term, but since the late 1990’s, bond yields have been falling in line with inflation. Following the Banking Crisis in 2008 yields went markedly lower as Central Bank intervention in Bond markets drove the ‘yield’ down to the lowest levels in history, in turn sending the capital values of Bonds soaring.
Now however, Germany, France, Switzerland, the Netherlands and Sweden have joined Japan with negative yields, which means that if you place your money in the Sovereign Bonds of these countries you are guaranteed to receive less than you invested when they mature. Furthermore, this is excluding the real return after taking inflation into account.
Why would anyone place their money in Government Bonds in the knowledge that they will get back less than they invested?
The answer is they won’t, unless they are terrified that there is going to be a significant recession or stockmarket collapse. They are doing it for safety, or, and this is much more likely, they are professional managers who are anticipating that the Federal Reserve and other Central Banks will cut rates and embark on more QE, where the Central Banks purchase Sovereign debt using ‘conjured money’ to lower the yields and support asset prices. This is the ‘carry trade’, low risk speculation by ‘front-running’ the Fed. It has seen a handsome profit for the traders.
But as rates have fallen and turned negative, conversely, the value of the Bonds has skyrocketed. And this has a knock-on effect on the values of all debt, including credit grade corporate bonds and high yield or ‘junk’ bonds.
John Authers on Bloomberg this week argues that “there has been a tendency since the financial crisis to label any market that is rallying or deemed overvalued to be in a ‘bubble’”. But it is difficult to argue that Government Bonds are not extremely expensive.
So where does this leave us?
It is blindingly obvious that there are many reasons to be concerned for the economic outlook and global stockmarkets. These include the US/China trade tensions, the Eurozone slipping into recession and a hard ‘no-deal’ Brexit for the UK. But the most important concern of all is the US Federal Reserve being too slow to reverse the monetary tightening that they started in 2018.
But, “if a recession is coming, it is not ‘baked into the cake’ at the moment” suggests Ed Harrison writing on Credit Writedowns. “Jay Powell, Chairman of the Federal Reserve has time to act”.
We have also seen a number of commentators suggest that recessionary fears are being overblown. Interviewed on Bloomberg today, Michael Crook a strategist at UBS said “we don’t see the probability of a US recession in the next 12 months”. Charles Dumas, Managing Director at TS Lombard went further; “we don’t see a US recession”.
Should the economic data from the USA improve and the US/China trade war be resolved, a recession would be off the table. There would be a quick scramble back into risk assets.
Value remains one of the best measurement for investments. Having lagged global markets for the past five years, UK equities are currently considered to be very good value; price/earnings ratios for many UK companies are at their lowest for decades. Furthermore, despite the political uncertainty, the economy has remained resilient, reflected by corporate profits and record dividends. In fact the difference between the average FTSE-100 UK company dividend and the 10-year UK gilt yield has not been as wide since the 1930’s. This all points to considerable scope for a revaluation of UK stocks once the political environment improves.
We remain overweighted to good quality UK companies, with diversification through inflation linked gilts and real assets including selected commercial property funds, forestry and gold.
If you would like to discuss any issues relating to markets or investments please do not hesitate to contact us.