Many factors were at play: fears of an Argentinean default, continuing unrest in Hong Kong and a slew of lacklustre economic figures – but one factor dominated all the misery, the inversion of the US yield curve. This is because all recessions in the US since the Second World War have followed in the wake of a yield curve inversion, where long 10-year government yields fall below short 2-year yields. Historically, this has proved to be one of the best indicators of an upcoming recession.
Consider the facts before panicking
Sounds alarming? Yes. But should it trigger panic and an equity sell-off? Definitely not.
For if you attribute the inversion of the yield curve significance, then you must rightfully accept what follows and see how the economy and equities actually reacted subsequent to previous yield-curve inversions. Here, there are two facts in particular we would highlight:
*Since the mid-70s, it has taken an average of 17 months from the yield curve inverting until the economy slides into recession
*And even after the yield curve has inverted, equities have over the same time span only given a negative 12-month return in two out of seven cases, while the average 12-month return on equities has been 14.1%.
What is the yield curve exactly?
The yield curve shows the correlation between bond yields and maturities, and normally the curve rises – the longer the maturity, the higher the yield. The reason for this is simply that lending money over longer periods of time is more risky, as more can go wrong, so lenders require a higher rate of interest.
In contrast to this normal state of affairs, an inverted yield curve is one where short yields are higher than long yields. An inversion of the yield curve could be prompted by market expectations that the economy has reached a point where the Fed (US central bank) needs to stimulate again (which the Fed is in the process of) and the expected future rate cuts are first priced into long yields, which thus dip below short yields.
No indication of recession in our models
Both the US and the global economy have definitely produced a string of weak signals in the past year, in part due to the trade war between the US and China. Nevertheless, there is nothing in Danske Bank’s models to indicate an imminent recession, and in the bigger picture it is also uncertain how much significance we should attribute to historical yield patterns. Remember that since the financial crisis in 2008-09, central banks have pursued monetary policies with a hitherto unheard of degree of looseness.
Looking beyond the current noise and turmoil, we still see a global economy with relatively sensible rates of growth, where not least the very accommodative monetary policies of the central banks will, in our opinion, help keep things on an even keel and support corporate earnings, even if the sea is rough. There are, to be sure, significant risks at the moment; nevertheless, we expect a more attractive return from equities than from bonds over the coming 12 months and are maintaining a slight equity overweight in our portfolios.
And with respect to the inversion of the yield curve, we actually see a greater risk in selling out of equities for this reason than holding on...
Disclaimer: Danske Bank has prepared this material for information purposes only, and it does not constitute investment advice. Always speak to an advisor if you are considering making an investment based on this material to establish whether a particular investment suits your investment profile, including your risk appetite, investment horizon and ability to absorb a loss.
