In his latest note, Eoin Murray, Head of Investment at Hermes Investment Management, discusses the four words he dreads more than anything.
There are plenty of words people in investment use to convince themselves – or others – that things are going to be OK. “This trade can’t fail”, “the market is rational”, “equities always go up”, are prime examples.
But for me, the worst is: “This time it’s different.” Why? It invariably isn’t.
The latest use of this maxim is by people unconcerned about the possibility of the yield curve inverting. The yield curve tracks short and long-term interest rates that fuel the traditional banking model. Short-term rates are usually lower, so it is cheaper for banks to take deposits, and the longer-term rates are higher, so they can issue loans and take a turn on the difference. Any disruption to this system sees the model break down. An inversion of the yield curve occurs when short-term interest rates are higher than long-term ones – it has been a reliable predictor of recessions.
Of course there are many different ways of measuring the steepness of the yield curve, or the term spread. A recent paper by the Federal Reserve Bank of San Francisco suggests that it doesn’t actually matter whether we use 30-year minus 3-month, 10-year minus 2-year, or even attempt to include expectations:
Figure 1: Predictive power of different term spreads:
Source: Federal Reserve Bank of San Francisco, Hermes Investment Management
All are excellent predictors of future recession, even excluding the period of potential distortion given by unconventional monetary policies post the global financial crisis (GFC).
The bad news for those worrying about the current yield curve inverting is that it may be too late, because some versions already have and the direction of travel is pretty clear. Setting aside the nominal yield curve and looking at the real one, calculated by discounting breakeven inflation at each point of the curve, it inverted earlier this summer:
Figure 2: Nominal vs real yield curve (10y-2y):
Source: Bloomberg, Hermes Investment Management
Additionally we know that corporate bonds trade at a slight premium to government-issued debt, and the corporate yield curve has also already inverted.
Figure 3: Corporate yield curve:
Source: Bank of America Merrill Lynch, Hermes Investment Management
Similarly, the global nominal yield curve is also inverted, suggesting a global recession is on its way.
The counter theory is that there are quite good reasons why long-term rates are being pushed down and causing this phenomenon. Dynamics from QE may be depressing the term premium component of long-term yields – “some part of the flattening may not be worrisome at all”1. However, there is sufficient uncertainty around the effects of QE on interest rates that there really is no clear empirical evidence to suggest that “this time it’s different”.
At the same time, in the US, the Fed is raising short term rates as its economy improves – inflation (core PCE has at last reached the magical 2% and earnings are accelerating beyond a comfort zone). So why is nobody concerned about this potential inversion? Historically, the yield curve inverting has been a phenomenal predictor of recessions - it has usually taken between six and 18 months to filter through after it occurs.
For investors, the anticipated economic malaise associated with a recession can easily erode wider confidence and tends to push down risk assets. Investors also abandon higher-yielding but less sound investments that seemed attractive in good times, favouring a flight-to-quality approach. In credit markets, investors should expect to see covenant weakness exposed, as defaults mount and recovery rates fall from the current relatively high bar. So what can investors do?
History suggests several areas, while not outright prospering, will fare better than others in times of recession. For example, in the property sector, stocks and bonds associated with renovation activity are more likely to prosper than new builds - this holds true for other industries too. Utilities and consumer staples tend to outperform in tougher times. Quality earnings and long-term cash flows become even more valuable, and hint at companies less likely to default. And there will always be opportunities for savvy, long-term investors to pick up the debt stock in good businesses that become undervalued.
Looking on the bright side, there are reasons why we might avoid recession. For the moment, earnings are quite strong globally despite the effects of increasing protectionism and anti-globalisation, and recession prediction based on the nominal yield curve requires an actual inversion, not simply getting closer.
So will it be different this time? Maybe – but not thinking about the possibility is a big risk to take if it’s not.
The above is published solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instrument. The views and opinions contained herein are those of the author and may not necessarily represent views expressed or reflected in other Hermes communications, strategies or products.