Inverting bond yield curves – a traditional warning of an impending recession – have led many investors, including Robeco, to reduce their equity holdings or go underweight credits and high yield bonds.
However, those staying out of such assets – particularly equities that continue to rally – risk missing out on returns that may still accrue as recession fears move farther out and macroeconomic fears over the US-China trade war and Brexit become overblown, he says.
“With a new all-time high for the MSCI World Index in euros, and the index already up 14.5% in the year to date, it is perhaps hard to escape a feeling of ‘what you see is all there is’,” says Van der Welle, strategist with Robeco Investment Solutions, which manages a suite of multi-asset funds.
“Prolonged weakness in the Eurozone, stalemate Brexit politics or another postponement of a US-China trade deal may fuel another turbulent market episode that warrants battening down some hatches. But a critical view of three underlying fundamental drivers suggests one should still be rewarded for taking equity risk on a 12-month horizon.”
The first of these drivers is the global growth scare that is now fading. “For over a year now, financial markets have been facing a barrage of disappointing macroeconomic data from most parts of the world, notably China and Europe, where the fallout from trade tensions with the US has been mostly concentrated,” says Van der Welle.
“Eventually, the bond market stumbled upon this, and has rallied hard since last October, flattening yield curves. In a twist of irony, the dovish U-turn by the US Federal Reserve at the start of 2019 eventually aggravated the growth scare, with the ensuing yield curve inversion suffering from the law of unintended consequences of recent Fed utterances.”
“It seems clear now that the Fed’s move to pause interest rate hikes was instigated by tightening financial conditions and the slowing macroeconomic momentum, not a pre-emptive move to mitigate imminent recession risk.”
Van der Welle says the first green shoots of a rebound have already appeared, with strong readings in March for two reliable indicators: the US Institute of Supply Management (ISM) and the Chinese manufacturing Purchasing Manager’s Index (PMI). A reacceleration in Chinese money growth also indicates that global earnings revisions are set to improve; such revisions usually coincide with a rerating for equities, as shown in the chart below.
So, if global growth starts to surprise to the upside in the near term, why then shouldn't investors take such a powerful recession predictor as yield curve inversion in their stride and remain invested in equities over the medium term?
“Historically, the MSCI World Index has generated an average return of 7.3% in the 12 months following a yield curve inversion, whose start date is determined by the 10Y-1Y US government bond,” explains Van der Welle.
“This subsequent return estimate suggests that optimists should triumph for another year, as this is below, but still close to, the 8.0% annualized return global that equities have generated since 1900. That is not to say the yield curve inversion signal should not be taken seriously; every post-war US recession has been preceded by one.”
“However, long and variable lags between the incidence of inversion and the actual recession date, where the average lag is 18 months, matter here for deciding whether to stay the course or not. Procyclical fiscal stimulus in the US ahead of the 2020 US presidential elections and central banks that are prone to err on the side of caution could push recession risk somewhat further out this time.”
Meanwhile, interventions by US Treasury Secretary Steven Mnuchin seem to carry a lot of weight. “When he called major US bank CEOs late December and tweeted that President Trump did not intend to fire Fed Chairman Jerome Powell, the closely watched Economic Policy Uncertainty Index started to roll over from an all-time high, and has been declining ever since (see chart below),” says Van der Welle.
“Admittedly, global economic uncertainty is still elevated, given the ongoing trade tensions between the US and China, and the shifting sands of the Brexit process. But there are green shoots here as well. Constructive trade talks held in Beijing last week keeps the expectation of a deal alive, while the probability of a hard Brexit is still judged by FX markets to be a tail risk, with a ‘Brexit in name only’ the more likely medium-term outcome.”
“In short, one should stay the course with regard to exposure to risky assets. However, there is a caveat: late cycle investing is not ‘business as usual’, since an episode of flattening yield curves is usually followed by higher equity volatility. So, we battened down some hatches last month by lowering our overweight in global equities and maintaining higher cash levels in our multi-asset funds.”
“There is also reason to be selective within risky assets in this phase of the cycle. If the growth scare fades, a rebound in depressed bond yields will leave duration-sensitive fixed income categories such as investment grade credit and high yield more exposed relative to equities.”
“High yield bonds did not manage to outperform global equities after the 2006 yield curve inversion, while the 1998 inversion saw a subsequent 23% outperformance of global equities. We have expressed that view by underweighting credits and high yield in the portfolio, preferring to play the extra time left in this cycle through equity exposure.”
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