Summer Worries: Yield Curve Inversion

CIO Chris Perras discusses the recent yield curve inversion, what it typically means for the stock market, and whether it affects our view for the markets going forward.

Chris Perras: Good afternoon. I’m Chris Perras, Chief Investment Officer at Oak Harvest Financial Group, and welcome to the August 16th edition of our weekly Stock Talk Podcast: Keeping You Connected to The Money. It’s summer. It’s blistering hot in Houston with about seven straight days over 100 degrees temperature. The stock market is down about 6% to around 2850 on the S&P 500 off its 3025 all-time highs only 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% to 6% pullback in the S&P 500 in the third quarter. This can be found on our website at oakharvestfg.com under the investment management section or by Googling Oak Harvest Second Half, 2019 Outlook. This week’s topic [unintelligible 00:01:02] for the markets in 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 short-term interest rates. How much more does it cost to borrow money for 10 to 30 years first borrowing money for say three months or two years. Investors worry about the yield curve inversions because historically there is a pretty good forecaster 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 US economy has been slowing since late January 2018, and the Trump Tax Plan was passed and the China trade rhetoric first began. Not coincidentally, the overall stock market has gone nowhere since late January 2018. The asset classes and sectors of the stock market that are the most sensitive to changes in economic activity have performed poorly versus the overall market in the last 18 months.

Throughout the last 18 months, including the so-called Goldilocks described the period in the middle of 2018 by others, 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, and real estate investment stocks, and two-year bond funds.

This week one of the many yield curves that investors watch the 2-year treasury to the 10-year treasury inverted for the first time, since we exited the 2008, 2009 recession. Inversion just means that it costs more to borrow money for short periods of time than for long periods of time. 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. First, the yield curve is a leading, not coincident indicator of the economy. Inversions of the 10-year and 2-year interest rates have led to US recessions by almost a year and a half on average. Almost 18 months with a range being a year to two years. Secondly, the inversion doesn’t portend an immediate failure and downside move in either the economy and stock markets. On average, the S&P 500 has returned about two and a half percent in the three months after the first inversion, while it has gained almost 5% in the following six months and almost 15% in the following two years.

In fact, looking at the most more recent history of inversions over the past 30 years, we threw out the ultra-high inflation periods in the late ’70s. The stock returns look even better. Listeners, listen to this, its three months return after the inversion has been on average 3.1%. Its six months return after the inversion has then on average 9.4% and a one-year return has been almost 20%.

Coincidentally, 20% higher than the current level would be almost 3400 on the S&P 500 in August of 2020, which is almost exactly where both Oak Harvests and the Ford Option markets believed the S&P 500 can be into the 2020 election cycle should a pro-business pro-growth candidate, President Trump reappear. Even former federal reserve chairman, Janet Yellen was out last Wednesday addressing this topic.

In fact, she said, “The markets may be wrong this time in trusting the yield curve inversion as a recessionary indicator. The reason for that is that there are a number of other factors in other markets, other than market expectations about the future path of interest rates that are pushing down long-term interest rates.” When asked if the United States has headed into a recession, Yellen said, “I think the answer is most likely, no, I think the US economy has enough strength to avoid that, but the odds have clearly risen.”

She goes on to add, “There is an international arbitrage going on in the bond market that is helping drive US long-term treasury interest rates lower.” 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. Where recently, we have been positioning the portfolios for an economic upturn in the fourth quarter of 2019 through 2020 on the back of President Trump positioning for growth in re-election.

Admittingly, the last four weeks’ rally and bond prices, and a reduction in yields, have gone much farther and faster than we expected. The more aggressive stance that the president has taken towards China, the last few weeks, with him launching new tariffs slated for September 1st out of the blue is now causing economic uncertainty, slower growth, and higher volatility in all markets, whether it’s treasuries, currencies, commodities, or equities.

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 here at Oak Harvest. For now, the team at Oak Harvest is using the higher volatility to add to names that we believe will be rewarded in the fourth quarter of 2019 and beyond, and looking to sell positions that we have losses in that we do not expect to recover as fast.

If we begin to see the data and feel that the ongoing 18 months slowdown that we have been experiencing in the US since January 2018, is not looking to change course early in the fourth quarter and beyond, we will begin to tactically adjust the portfolios for a continued low and slow growth economy versus our expected low, slow, and go scenario. If you find this content helpful, please forward it to friends and have them give us a call at 281-822-1350, go browse or update a website and new content at oakharvestfg.com. Our main job at Oak Harvest is to help you retire only once in your life with a customized retirement planning, many blessings. This is Chris Perras.

Speaker: The proceeding content expresses the views of the speaker and is for informational purposes only. It is based on information believed to be reliable when created, but any cited data, statistics, and sources are not guaranteed. Content ideas and strategies discussed may not be right for your personal situation and should not be considered as personalized investment, tax, or legal advice or an offer or solicitation to buy or sell securities. Investing involves the risk of loss and past performance does not guarantee future results.