James Inglis-Jones

Yield curve inversion – why we’re not worried, yet

James Inglis-Jones

With global bond yields at such low levels, we believe the implications of yield curve inversion on equity markets are being overstated. While a global slowdown is a risk, we have our own proprietary measures of investor anxiety, which suggest equity investors have already factored this in. There is little evidence of investor complacency – which for us would be a red flag.


Yield curve inversion has become the hot topic for market commentators in 2019.


The shape of the yield curve – created by plotting bond yields against their maturities – gives a strong indication of investors’ expectations of future economic conditions. An upward sloping yield curve signals an economy which is expected to grow, leading to higher inflation and rising interest rates, while a downward sloping ‘inverted’ yield curve suggests a slowing economy where deflationary conditions necessitate rate cuts.


The picture is of course more complicated than this. Yield curves can also be shaped by structural factors such as large groups of investors (such as pension funds) needing to buy bonds of a certain maturity, while a ‘term’ premium is also often thought to be built into yields of longer maturity bonds to compensate for liquidity risks.

But if an inverted curve might signal economic slowdown, it is obvious why this phenomenon has caused alarm recently.


At the time of writing, a number of developed countries’ yield curves are inverted at the two and 10 year level, meaning that two year government bonds offer an annual return which is greater than 10 year bonds. The UK can be counted among this group.


The predictive powers of bond yield curves are thought to be such that the Federal Reserve Bank of New York converts the US yield spread between three months and 10 year bonds (which is negative when inverted) into a Probability of US Recession index:


Probability of US recession predicted by treasury spread

As the chart shows, the spikes in recession probability predicted by yield curves do seem to correlate very highly with actual incidences of economic recession, which are indicated by the shaded areas.


So how worried should we be about the yield curve inversion?


Perhaps we should first take a look at how worried everyone else is. The Bank of America Merrill Lynch (BofAML) August Fund Manager Survey tells us that a third of participants expect a global recession in the next year. Of the other tail risks highlighted by the report, over 50% of respondents are concerned by Trade Wars, while monetary policy, Chinese slowdown and bond market valuations also rank highly among the concerns.


One of the more quantitative elements of our Cashflow Solution investment process could be useful in helping put these concerns into context. We have developed a proprietary indicator of investor anxiety which we believe gives a useful signal as to the future direction and style bias of equity markets.


Our indicator tells us that investor anxiety is currently elevated in Europe, but not yet at very high levels:


Investor anxiety Europe 

In the UK, anxiety is closer to very high levels:


Investor anxiety UK

Although our quantitative measures paint a picture of an anxious investor, this doesn’t make us nervous. We use it as a contrarian indicator within the Cashflow Solution process, which means that it is actually complacent investors rather than anxious ones that imply a negative equity market outlook.


We’ve back-tested our anxiety indicator from 1988 and found that when investors hit “very worried” levels the range of subsequent 12 month equity market returns ranges from 87% to -24%. When investors become “very complacent” however, the range is a more ominous 29% to -36%.


Not only are investors showing low signs of complacency, companies are being relatively responsible in their investments, and – while not cheap – through-the-cycle measures of equity market valuation are not troubling. The basic pillars of a fairly constructive equity market outlook look to be in place.


Of course, the outlook for the stockmarket and the economy are not one and the same. To adjust equity market exposure based upon a correlation between yield curve shape and economic conditions would be ignoring this simple rule. Research published just a few weeks ago (‘Inverted Yield Curves and Expected Stock Returns’, Fama and French) supports this point. This study used data from six countries, going back to 1975. It found no evidence to support a hypothesis that inverted yield curves predict lower equity returns than normal.

For these reasons, yield inversions are not causing us sleepless nights. Investors’ anxiety levels suggest they are alive to the threat of economic deceleration – a far less worrying scenario than if asset prices instead reflected investors who were complacent to the prospect of a looming downturn.

The yield curve is a much more accurate recession predictor when starting yields are high, and they are not today. In fact, they are at incredibly low levels, the likes of which we’ve not seen before in our lifetimes: over 40% of European investment grade debt now trades on a negative yield while US 30 year government bond yields recently hit all-time lows. 


Moreover, economic outcomes and stockmarket returns are less closely linked than intuition would suggest. As the yield curve inversion causes rising alarm, this is a point worth remembering.

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Key Risks

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. Investment in Funds managed by the Cashflow Solution team involves foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The Liontrust European Growth Fund holds a concentrated portfolio of stocks, if the price of one of these stocks should move significantly, this may have a notable effect on the value of the respective portfolio. The Liontrust Global Income Fund's expenses are charged to capital. This has the effect of increasing dividends while constraining capital appreciation. 


The information and opinions provided should not be construed as advice for investment in any product or security mentioned, an offer to buy or sell units/shares of Funds mentioned, or a solicitation to purchase securities in any company or investment product. Always research your own investments and (if you are not a professional or a financial adviser) consult suitability with a regulated financial adviser before investing.

Friday, August 23, 2019, 10:44 AM