The Recent Yield Curve Inversion Should Not Alarm Investors
On Wednesday the bond yields inverted for the first time since 2007 causing a big down day in the markets. Traders and algorithmic programs began to sell even though the inversion happened for a brief period and closed without the inversion. The Surevest Investment Committee does not believe investors should panic as we will discuss this this week’s market update.
A yield curve is a graphical depiction of bond yields across time. In a normal environment yields on the short end of the curve are lower than yields on the long end. The reason that is the case is simple and intuitive. For instance, if you lend a friend $5,000 and were thinking of charging an interest rate on the loan, two big factors would determine the amount you charge: 1) how risky is your friend as a borrower and 2) how much time would go by before your friend pays you back. In other words, if your friend is scheduled to pay you back in two years vs ten years, you would charge less for getting paid in two years because there is less risk that something can prevent your friend from paying you back in two years than ten years. The bond yield curve works in the same way. However, there have been occasions where what you would charge your friend for a two year loan would be higher than if the borrowing period was ten years.
In the bond market, this situation happens when traders believe the economy will stall and go into a recession. Therefore, traders purchase bonds, in this case the 10-year U.S. Treasury bond, because it is seen around the world as the safest place to put money. The logic is that if the economy stalls, corporate profits will decrease which will lead to lower stock prices. That is why there was a selloff on Wednesday. However, things are not that simple and when you look at the data closely you begin to see why investors should not panic.
The yield curve inversion does not always lead to a recession. In fact, economist Ed Yardeni has noted that an inverted yield curve can occur prematurely. For example, it turned negative a couple of times during 1995 and 1998, but a recession did not officially begin until March 2001[i]. Therefore, we don’t think a recession is certain and more data is needed to make an intelligent decision.
One thing to note on the chart above is that on previous inversions, the Federal Reserve had been raising short term rates. That is not the case today, the Fed is more accommodating and is ready to step in if the economy needs assistance. On the economic front, the U.S. consumer, which accounts for 70% of GDP, is still confident and continuing to spend, unemployment is at record lows and wages are increasing without causing fear of inflation. This is all positive for stocks.
We compared the year 2000 inversion to today to provide some context. The yield curve inverted February 2000, and at that time the 10-year U.S. Treasury bond was trading a little over 6%[ii], the forward price-to-earnings ratio on the S&P 500 was a little over 23x[iii] and the dividend yield was 1.23%[iv]. Today, things are very different with the 10-year U.S. Treasury bond trading at a yield of 1.53[v]%, the forward price-to-earnings ratio on the S&P 500 is about 16.5x[vi] or almost 40% cheaper and the dividend yield is about 2%[vii]. We chose the 2000 inversion to show that even though we have seen all time market highs this year, the valuation on the S&P 500 is still fair. It becomes a simple proposition now, would you rather invest in the S&P 500 that pays a higher dividend than U.S. bonds, has a higher possibility of capital appreciation, and is trading at a better value? We think investors will put their money in stocks even though there will be short-term increased volatility.
Another aspect to consider is the amount of world debt that is paying negative yields. Not too long ago, the concept of negative yields was impossible according to economic theory, yet there is $16 Trillion of Negative-Yielding Debt in the world. [viii] To put it in perspective, that is a little over 75% of U.S. GDP. Germany’s 10-year bond is trading at -.71%, while Switzerland and Japan are trading at -1.19% and-.24% respectively. That means that even though our 10-year bond is trading at 1.53%, it is much higher than other world developed countries, which means money will flow to the U.S. and put additional pressure on U.S. bond yields. We further foresee foreign investors moving from U.S. bonds to U.S. stocks for the same reason U.S. investors are doing it. This is positive for stock prices.
I want to turn the attention to the difference between a trader and an investor. This is important because it is commonly overlooked. A trader is looking to profit from the short-term swings in the market and makes decisions based on news, emotions and technical analysis (acronym N.E.T.) An investor will not focus their decisions on short-term market swings, but rather will look at factors that influence the success of a company in the long-run, such as management quality, value proposition of the firm and the price that is paid for the investment (acronym M.V.P.) At Surevest, we focus on what has reliably proven to be a better approach, that is we use M.V.P.
We don’t think investors should worry about the bond inversion or any other short-term signal that detracts from a well thought out financial plan and proper investment strategy. When we get short term pull backs, we are ready to capitalize because it will allow us to purchase good companies at better prices. We thank you for your trust and we will continue to work hard to help you and your family achieve your financial goals.
Don’t forget to tune into Making Money with Charles Payne to listen to Robert Luna, Surevest CEO & Chief Investment Strategist, provide his insights on the markets. The show begins at 11 am PST on Fox Business. As always, please reach out to your Surevest financial advisor with any questions.
