Asset Allocation

The bond market has been telling us for a while all is not well with the US economy. An escalation in trade tensions between the US and China, the US and Europe, the US and India and now between the US and Mexico has the bond market very nervous. For the most part, Wall St has had its eyes wide shut to this message…until now.

The message on Bond St

The message coming out of the bond market over the past few months has been one of nervousness, of interest rate cuts and of lower inflation expectations. Bond yields are falling and, much like what barometric pressure is to the weather, when they fall it’s often a sign that some kind of storm is coming.

Long-term bond yields peaked in November last year. This coincided with the decision by the Federal Reserve (the Fed) to raise interest rates. Despite the fall in bond yields, the Fed raised interest rates further in December.

Today, long term bond yields are more than a full percentage point lower than where they were in November. So while the official interest rate has moved up, longer term bond yields have moved down. This reduction in long term yields relative to short term yields, known as curve flattening, is the bond market signalling that the central bank has tightened monetary policy too much and that interest rates in the future need to be lower.

The message coming out of the bond market over the past week or so has gotten louder. The difference between short-term and long-term interest rates has not only moved lower, it has turned negative. This is known as an inverted yield curve.

The message for Main St

Inverted yield curves are rare beasts having occurred just seven times over the last 50 years or so. When they happen they usually bring a clear message - every one of the past seven inversions in the US has led to a recession.

The message coming out of the economic data suggests growth in the US is at best mixed. The table below shows where a number of economic indicators currently sit compared with where they were a year ago.

Clearly the sectors most exposed to trade have slowed down considerably such as exports, durable good production and industrial production. The consumer is still in healthy shape but this is not expected to last.

Source: Bloomberg

The US consumer is expected to come under pressure as tariffs hikes on Chinese and now Mexican importers is passed through to final prices. As the bond market is suggesting, rather than lead to higher inflation, higher prices due to the tariffs will cause consumers to withdraw their wallet. Signs of pressure are already beginning to appear in some sub-sectors of the equity market. The department store sub-index, for example, has been sombre since January and outright depressed since late April this year.

The message for Wall St

For much of the past five months, the US equity market has been deaf to the message being sent by the bond market. The 25% euphoric rise in the S&P 500 from its December 24 low to the peak at the end of April was driven more by sentiment and momentum than anything fundamental. Characteristic of this euphoria, the rise was narrowly based with just four stocks (Apple, Amazon, Microsoft and Facebook) responsible for 20% of the gains.

The message now for Wall St is one of caution. The table below shows the association between the bond market, the economy and the equity market.

Three messages come out of this table. First, once the curve has inverted, it takes an average of 8-months before the Fed begins to cut interest rates. The second message is that a recession follows an inversion with a lead time of between 5 and 16 months. The third message is that an inversion is not necessarily immediately bad for equities although on a 6-12 month view this message is more mixed. Deeper recessions usually cause sharper share-price declines (as was the case in 1973). Expensive stock markets (like the 1998-2000 technology bubble) are also more vulnerable.

Source: Bloomberg

It is important to note that equity bear markets have been associated with U.S. recessions. This was the case with five of the last seven recessions. The recessions that began in 1969, 1973, 1981, 2001 and 2007 all coincided with equity bear markets. This makes the inversion of the yield curve a valuable early warning signal and suggest a more defensive investment state of mind is required.

So what is the message on the street? History suggests if the inversion of the curve persists over the next few days, it is likely the US economy will fall into recession within the next 1-2 years. It is likely the Fed will be cutting interest rates in this environment and investors should be defensively positioned.

We are happy to remain overweight cash and fixed income in this environment and underweight equities, particularly the US and Europe.



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