Chief Investment Strategist and Chief Economist
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While we don't dismiss the yield curve's message, we continue to make a positive investment case with global diversification at its core.
A powerful warning signal for the US economy has just flashed up. The yield on the US 10-year Treasury note has dropped slightly below the Fed’s policy rate, thus causing the yield curve to invert. Over time, such inversions have been the single most reliable predictor of US recessions – figure 1. Going back to the 1970s, inversion has preceded every economic contraction by an average of about ten months. It has also tended to lead US equity market peaks by an average of four months. So, have the US expansion and equity bull run now passed the point of no return, with a recession and bear market looming ahead?
Source: Haver as of March 25, 2019. Indices are unmanaged. An investor cannot invest directly in an index. They are shown for illustrative purposes only and do not represent the performance of any specific investment. Past performance is no guarantee of future results. Real results may vary.
Unlike some investors, we don't dismiss the inverted curve’s current message entirely. Its significance over time has been too great for that. However, we would also emphasize that the yield curve is not infallible. On two occasions over the past half century or so, inversions were not followed by recessions. Instead, the yield curve went back to its normal, non-inverted state before later re-inverting ahead of an actual recession. The late 1990s saw the most recent case of this.
While not ignoring the inverted yield curve, we also don’t believe that the US economy and bull market have indeed passed the point of no return. Importantly, we think that the Federal Reserve’s decision to end its damaging rate hikes and quantitative tightening policy have lowered the risk of a recession in 2019. We expect the signs of significant economic weakness seen in the first quarter to subside over the rest of the year. Still, policymakers in the US and elsewhere need to act wisely. Unresolved issues such as international trade friction and the UK’s exit from the European Union continue to create uncertainty and the potential for negative shocks.
With widespread fears of a deepening economic slowdown, what should investors do? First, we recommend resisting the urge to try and time the markets based on past yield curve inversions. Aggressively switching back and forth between risky assets and cash has cost investors dearly over the long run. Next, we reiterate our advice to help safeguard assets by building globally diversified multi-asset class portfolios. We have also lately taken further steps to raise the quality of our allocations, shifting some of our investment grade US fixed income allocation into longer duration bonds last week. However, we remain overweight both global equities and fixed income. If we are wrong about the outlook for the US expansion and bull market, we see global diversification as a way of mitigating the risks to portfolios.
Clients can read Global Strategy Bulletin | Before the Peak: The Truth About Inverted Curves by logging in.