By now you’ve probably seen the headlines about the dreaded inverted yield curve – and the impending recession.
Renewed recessionary fears have caused equity markets to wither, resulting in a cascade of articles and new analyst predictions.
So what’s the yield curve and why does it matter?
The yield curve is a line plotting out yields across various maturities.
Typically it slopes upward, because investors demand higher rates to hold a note or bond for a longer period given the risk of inflation and other uncertainties.
An inversion occurs when the yield on long-term debt drops below its shorter-term peers – the inversion of long-term and short-term rates can signify a lack of confidence in the future economic outlook.
And for the first time in over a decade (2007) we’ve seen a slight inversion, between the 3 month and 10-year yields.
But so far, the majority of the yield curve – with other maturities has yet to follow suit. The all-important 2 to 10 year yield spread remains positive.
That’s important folks, because historically the 2 to 10 year spread is a strong predictor of a recession.
The chart below, dating back to 1979, indicates where an inversion in the short and long term yields have occurred and where a recession has followed thereafter.
I’ve highlighted areas since 1990 where an inversion of the 2/10 yr yield curve preceded a recession. To the far right (circled) is where yields are currently. So it’s something to watch.
Even when the yield curve inverts, markets do not crash overnight.
Typically, recessions have arrived about a year after an inversion occurred.
In other words, let’s not hit the panic button just yet…
Is recession imminent?
The simple answer is no. It’s often said that economists have predicted 12 of the last 5 recessions.
Remember, an inverted yield curve is a predictor, not a crystal ball!
Although every recession has been preceded by an inverted yield curve, not every inverted yield curve has lead to recession.
The first thing investors should remember is that rising rates don’t automatically spell doom for the stock market. This fact often gets lost in the wash of doom-and-gloom headlines from the mainstream financial media.
It’s a process – interest rates begin to rise because the economy is improving, and that is a good thing for equities. But eventually rates rise too much, choking off economic growth and causing a recession.
But the level where equities are affected by higher rates has actually been pretty well defined historically. The tipping point is pretty clearly defined at 5.0% on the 10-year Treasury.
And with yields on the 10-year Treasury at 2.41% right now, there’s still a long way to go until we get to that 5.0% level.
So what does this all mean?
- Some say a recession is imminent, some say we won’t have one.
- Some economists say that the recent inversion implies a 25%-30% probability of a recession in the next 12-months.
- Others say that recession historically occurs 6-18 months after inversion.
Well, that’s enough to make an investor feel like a squirrel in the middle of a six lane highway!
Don’t let this be you
In times of uncertainty, we find it helpful to lift the hood of the “market” and look to the internals for guidance.
Here’s what the technical data tells us now..
US Equities continues to lead all other asset classes – with International Equities and Commodities in the #2 and #3 spot, respectively.
Image provided by DWA
And not only does relative strength continue to point to a “risk on” market environment, but the trends of all three major US Equity indexes, the S&P 500 SPX, Dow Jones Industrial Average DJIA, and Nasdaq Composite NASD, remain in positive trends.
So right now, the leadership trends continue to point toward strength for the US market. Will this stay the case forever? No. But when it does change, we’ll adapt right along with it.
Although we have yet to see any major shifts on the macro level (asset class), there are some interesting sector developments investors will want to be aware of.
Investors concerned with the current state of the economy may want to take a closer look at both the Utilities and Real Estate sectors – as they have traditionally held up comparably well in a market environment of flat or inverted yield curves.
Interestingly, those two sectors also are currently two of the top three broad sectors over the past 60-days (behind Technology).
Real Estate in particular has been quietly making some noise, gaining traction and moving up one spot to #9 (out of the 11 broad sectors we track) – it’s within a whisker of surpassing consumer non-cyclicals to move to the #8 sector.
Although the sector remains in the bottom half of the 11 sector matrix, their returns have been nothing short of impressive.
Take a look at any of the bar charts below, comparing the performance of the S&P 500 Index to the top 8 Real Estate ETFs of our matrix.
In each of the various time horizons ranging between 6 months to 60 days – all 8 real estate ETFs (representing the top 8 out of 18 in our matrix) have beaten the returns of the S&P 500 – an index that is hot in it’s own right.
The takeaway is this, pockets of strength can be found in often overlooked sectors – sectors that aren’t necessarily ranked in the top 25% – and if investors want a chance at market beating returns – they’ll need to know how to locate them.
If you’d like to learn more about our process feel free to click here to schedule a consultation with one of our advisors.
Investors with at least $500,000 of investable inventory are eligible for a completely FREE portfolio evaluation. We can help you ensure your accounts aren’t exposed to more risk than you’re comfortable with, which could be important if these recession predictions eventually come to pass.
Click here now to see available appointment times.
And, as always, invest wisely.
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