Stock Talk Transcript — Summer Worries: Yield Curve Inversion
The following is a transcript of the 8/16/2019 episode of Stock Talk with Chief Investment Officer Chris Perras, of Oak Harvest Financial Group:
Welcome to the Aug 16th edition of our weekly stock talk podcast, “keeping you connected to your money.” It’s summer. It’s blistering hot in Houston, with seven straight days over 100 degrees temperature. And the stock market is down 6% to about 2850 on the S&P 500 — off its all-time high of 3025 just three weeks ago. While uncomfortable — yes, listeners — so far, it’s a normal summer in both Texas and the stock markets.
As we have laid out all year, we expected a normal year in the markets through the end of the third quarter. Our second half outlook, first laid out in mid-June called for a 5%–6% pullback in the S&P 500 in the third quarter. Both can be found on our website at www.oakharvestfg.com under the investment management section or by googling: Oak Harvest 2019 outlook.
Yield curve inversion
This week’s topic de jour for the markets and financial press has been the impact of the recent “yield curve inversion” on the markets. First off for new listeners, the term yield curve is just a fancy way to say, the difference between long term interest rates and shorter-term interest rates. How much more does it cost to borrow money for 10 or 30 years versus borrowing money for say three months or two years. Investors worry about yield curve inversions, because they are pretty good forecasters of major slowdowns in future economic activity which in turn lowers earnings for stocks and ultimately leads to lower stock prices.
As we’ve pointed out for well over a year, the rate of economic growth, inflation and corporate earnings peaked quarters ago. It was never “goldilocks” as many strategists called it in 2018. In fact, by almost every metric, the overall US economy has been slowing since late Jan 2018 when the Trump tax plan was passed, and the China trade rhetoric first began. Not coincidentally, the overall S&P 500 stock market has gone nowhere since late January 2018. The asset classes and sectors of the stock market that are most sensitive to changes in economic activity have performed poorly versus the overall market over the last 18 months. Throughout the last 18 months, including the so-called goldilocks described period in the middle of 2018, most measures of the yield curve were already declining. As others were discussing how great the economy was, the team at Oak harvest was out buying higher yielding, boring, staple stocks and real estate investment trusts and 2-year bond funds.
This week one of the many yield curves that investors watch, the 2-year treasury to 10-year treasury “inverted” for the first time since we exited the 2008-09 recession. Inverted just means that it costs more to borrow money for short periods of time than for long periods. This type of movement only happens when people are fearful about prospects for growth in the economy. With that inversion came the calls from the financial press for a looming or almost immediate economic recession. The facts behind this topic and issue are as follows:
- The yield curve is a leading — not coincident — indicator. And inversions of the 10-year and 2-year interest rates have led US recessions by almost a year and a half on average, almost 18 months, with a range being a year to 2 years.
- The inversion doesn’t portend an immediate failure and downside move in the economy and stock markets. On average, the S&P 500 has returned about 2.5% in the three months after the first inversion, while it has gained almost 5% in the following 6 months, and almost 15% in the following two years. In fact, looking at the more recent inversions over the past 30 years, post the ultra-high inflation periods of the late 70s, the stock returns look even better. Its 3-month return has been 3.1%, its 6-month return has been 9.4%, and 1-year return has been almost 20%. Coincidentally, 20% higher than current level would be about 3400 on the S&P 500 in August of 2020, which is almost exactly where both Oak Harvest and the forward option markets believe the S&P 500 can be into the 2020 election cycle should a pro-business, pro-growth candidate President Trump reappear.
Economic growth outlook
The team at Oak Harvest was cautious on economic growth during the second half of 2018 and favored more bond-like asset classes — like real estate and staples. More recently we have been positioning the portfolios for an economic upturn in Q4 2019 through 2020 on the back the President Trump positioning for growth and re-election. Admittedly, the last four weeks rally in bond prices and reduction in yields has gone much farther and faster than we expected. The more aggressive stance that the President has taken toward China — with him launching new tariffs slated for September 1 out of the blue — is now causing economic uncertainty, slower growth and higher volatility in all markets whether its Treasuries, currencies, commodities or equities.
Investment opportunities in elevated volatility
What does this mean to you as an investor?
During times of elevated volatility — and more so during times of distress like this week — we look for investment opportunities.
For now, the team at Oak Harvest is using this higher volatility to add to names that we believe will be rewarded in the fourth quarter of 2019 and beyond, and sell some positions that have losses that we do not expect to recover as fast. If we begin to see data and feel that the on-going 18-month slowdown that we have experienced in the USA since January 2018 is not looking to change course early in Q4 and beyond, we will begin to tactically adjust portfolios for a continued “low and slow” growth economy versus our expected “low, slow and go” scenario.
Share the insights
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