Time to Panic?
Portfolio theory, as used by most financial planners, recommends that you diversify with a balance of stocks and bonds and cash that’s suitable to your risk tolerance.
In early April, investment strategists and the financial media were up in arms with what they determined to be a ‘recession signal’. Below are some examples of the articles and investment notes from CNBC to Bloomberg which were released during that period not too long ago:
Potential Concerns
You may recall our previous article: Too Much Information — in this data-rich world, we find ourselves asking, this yield-curve-inversion, is it important? Yield curves generally slope upward, as the cost to borrow money/interest rate to lend money tends to be higher for the longer the duration of the debt. When short-term rates approach or overtake long-term rates, potential concerns may include:
The Federal Reserve could quickly raise rates to combat inflation and, in so doing, cause a recession.
Investors could be willing to accept lower relative interest rates to hold longer-term government debt, believing long-term prospects for the economy are currently poor.
The chart below shows the spread between the 10-year and one-year Treasury since October 1973. Inversions, or when the one-year was higher than the 10-year, are depicted in red. It appears that many recent yield curve inversions preceded a recession.
TREASURY YIELD SPREADS AND BUSINESS CYCLES OVER THE LAST 50 YEARS
Let’s Dig a Little Deeper
At first glance, it is understandable to have the urge to quickly hit the panic button in response to news of an inversion. However, digging deeper into the data shows that there’s not always a very strong relationship between inversions and recessions. Let’s extend the sample further back in time — recessions occurred during the following periods (1957- 1958, 1960-1961) where the yield curve did not invert; furthermore there was an inversion in 1966 where a recession did not occur soon after that.
So, how should we assess information about the yield curve’s inversion as a recession signal? To help verify the impact of yield curve inversions, the diagram below shows the results of an experiment run to check for any relationship between current yield spreads and subsequent stock returns. It’s a scatterplot comparing daily yield spreads between 10-year and one-year Treasuries versus the U.S. stock market return over the next six months. Each dot represents a day.
Yield curve inversions are highlighted on the left side of the chart. As you can see, there are lots of observations with positive returns for stocks as well as negative returns when the yield curve is inverted. The subsequent six-month returns range from greater than +40% to almost -40%. The data also appears cloud-like, with no linear pattern suggesting no strong relation between yield spreads and subsequent stock market performance.
Should I hit that Panic Button?
With no clear pattern about the impact of an inverted yield curve, is there a need to panic? Maybe not. Are there possible economic implications? Possibly. Should this indicator lead you to sell your stocks? Probably not. Investment strategists and economists have at their array countless signals to make predictions about the future, and some of these indicators border on the zany.
Former Federal Reserve Chair Alan Greenspan looked to the Men’s Underwear Index and decreasing sales as a sign of economic trouble. Another theory called the Hemline Index originated in the 1920s and posited that women’s skirt lengths rose and fell according to the prices of stocks. While there can be perfectly logical theories for how or why such signals can possibly give us inside information to invest better, we are better off remembering there is far more that is uncertain — no signal can accurately predict the market 100% of the time.
The Certain Uncertainty
When you invest you give up certainty, you take a risk and offer up your capital to companies for them to use to grow their business. In exchange for this risk, you receive a return. The ability to stay in your seat and remain invested provides the best chance for good results over the long term. Looking at a similar diagram that was shown previously (depicted below), you’ll notive that there have been both market runs and drops in normal and inverted yield curves situations. Regardless, investors with a long-term investment plan would have historically been rewarded for staying the course.
The stock market has delivered over the long term, despite yield curve inversions or recessions. With each and every piece of frightening news that looms on the horizon, it is not necessary for us to perpetually hit the panic button and hide in cash. For more conservative investors or investors who need to receive a payout from their portfolios, there are good ways to manage volatility, maximise their returns all without excessive trading in or out of the market.
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