Global growth is picking up; the consensus for equities is strong, albeit a dash of fear to check exuberance; US interest rates are rising but remain low in the wider context; “the search for yield” continues. What could possibly go wrong?
“Mind the flat yield curve” is a spoiler in waiting. This nerd-like concept is not exactly explained by its alternative: “term structure of interest rates”. It means that if the long-term outlook is promising, yield on progressively short to longer-maturity bonds – government or corporate – would be an upwards-trending line, as economic growth leads to higher inflation and interest rates.
Instead, there’s a mere 0.5% gap between two and ten-year US Treasury bonds, versus a stockmarket now confidently expecting Republic party tax cuts to boost growth to 4%; and we know how influential is the trend in US equities over global markets.
This is down from 1.25% at the start of 2017 so, if a reducing trend continues, the curve will invert mid-2018. It rings alarm bells for entrail-readers because the US Treasury yield curve has historically been a more reliable indicator of recessions than pundits: it’s inverted nine times since 1960, seven times followed by recession.
Whether or not investors should heed or reject this yield curve “warning” is quite a test of your philosophical make-up. Do you consider past experience a valid indicator of future likelihood, and that , while history may not repeat, it often rhymes? Or, can human affairs change radically to make the past barely relevant?
In favour of “it’s different this time”
The case goes, a flattening curve is to be expected when a key central bank is raising interest rates; two-year US Treasury bond yields being the most affected, while ten-year yields are low because the European Central Bank (ECB) and Bank of Japan persist to keep their interest rates ultra-low.
It means an international search for yield with liquid US assets a first priority, and, given an inverse relation between bond prices and yields, demand for US Treasuries keeps their yield low.
Also modern pressure on central bankers to be more transparent on policy intent lowers uncertainty about longer-term rates – ie bond yields go lower along with risk. Even if the yield curve does invert, interest rates are so low in historic context they won’t put a brake on the global economy.
Such optimists include Janet Yellen, according her last press conference as Fed chair. “There are good reasons to think the relationship between the slope of the yield curve and the business cycle may have changed. she said”.
Her outlook can also be seen as encouragement to Jerome Powell, the incoming chair, to keeping raising interest rates in pursuit of “normalisation”. Rate rises make sense now that US unemployment is low and falling, asset prices are high and lending standards relaxed. On a longer-term view, the Fed would then be better placed to cut rates when the next recession finally arrives.
Two glaring spoilers
Perhaps memories have faded about how former Fed chair Ben Bernanke declared in 2006 when short and long-term interest rates were similarly low by historical standards. “I would not interpret the currently very flat yield curve as indicating a significant economic slowdown to come,” he said.
Bernanke put faith in past recessions following from “quite high” interest rates, whereas lower rates would provide stimulus. Moreover (then as now), other indicators were consistent with solid economic growth. Yet a downturn began in 2007, just like the yield curve anticipated.
Certainly, “sub-prime” revelations kicked off the financial crisis and banks have since improved their credit risk management and liquidity in the last ten years. Yet global debt is now at least $75 trillion higher than in 2007, and the riskiest countries are issuing debt at a record rate – another follow-through of central banks keeping interest rates low, maintaining the search for yield.
Some 40% of emerging markets’ debt issuance in 2017 has been higher risk, returning about 10.5% this year as investor demand has pushed prices up and yields down, versus returns on US Treasuries of 2.5% and European debt 0.9%. Examples include Bahrain, Tajikistan, Iraq and Ukraine; less diversified economies potentially more vulnerable to change in the global financial system. How will they eventually refinance such debt, if that coincides with higher interest rates? Just another example of can-kicking.
Warnings also, from within the US Fed and Goldman Sachs
Jim Bullard, the St Louis Fed President, has declared himself a yield curve worrier: “There is a material risk of yield curve inversion over the forecast horizon if the Fed continues on its present course of rate increases; yield curve inversion is a naturally bearish signal for the economy. This deserves market and policy maker attention.”
To remain bullish after global equities have quite piggy-backed the US rally, you have to regard such remarks as lacking enlightenment how the world has changed, and/or that ex-investment banker Powell won’t match up to the Fed’s proper role – of taking away the party punch bowl when the time is right.
Goldman Sachs strategists also strike a cautious note, advising to stay invested but warning that Goldilocks conditions may have an expiry date soon. They suggest consumer prices will start creeping up in 2018 – already witnessed in the UK, if blamed as a temporary Brexit effect due to sterling’s fall – along with interest rates.
They contend that equities should be able to digest higher rates given gradual, predictable rises, but reckon on four happening in 2018 while the market is pricing as yet for three. “Sharply higher rates accompanied by a flatter yield curve could spell something more malignant,” they say.
The safer option?
Equity advice typically favours Continental Europe stocks/funds, citing impressive growth rates relative to the US/UK, and that the ECB is likely to reduce monetary stimulus only gradually. Bond-buying (QE) is due to reduce from €60 billion to €30 billion a month from January, although the ECB’s interest rate is 0% and its overnight deposit rate -0.4%. It has made clear that, should the eurozone economy deteriorate, then it would revert to more QE.
Thus, for the time being, asset allocators favour Continental Europe now that the risk/reward profile looks relatively dubious both for the US and UK, and debt issues rather spoil the emerging markets story.
Certainly, the ECB’s stance is looser than the Fed which is proceeding to cut its balance sheet (of assets acquired) from $4.5 trillion to $3.4 trillion, by $10 billion a month, as of last October, with a reduction plan to 2022. Meanwhile, the Bank of England is yet to unwind its £445 billion QE programme, its governor on the record as favouring higher interest rates initially.
Both the UK and Continental Europe central banks are keeping the punch bowl in play, just with less punch in. They are behind the curve versus the Fed, however, to establish higher interest rates before any downturn, otherwise QE would be left as the only policy response. My comparison shows the Fed recognises this as a priority, while Europeans are more relaxed or just don’t see enough substance of recovery like the US has enjoyed, to raise rates.
Company results are the reality check
So, the macro context implies a cautionary approach is warranted if capital preservation is your first priority. Equities will remain true to their underlying results, and US equities may enjoy support from higher dividends and buybacks as a result of the corporate tax cut, if not already priced in.
Profit warnings are creeping into UK announcements but, as yet, it’s a stock-picker’s market rather than one signalling a general downturn. I’ve described in the Stockwatch 2017 review how growth stocks are mostly richly priced, so 2018 will require more flexibility – eg judging if price falls get overdone in response to warnings, or portend worse. “Awareness to play the downside” may be a theme worth steeling for in 2018. Good luck!
This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.