There is continued debate in the financial media as to whether the yield curve is truly inverted (the 2- to 10-year portion of the curve is not inverted and the 5-10 and 5-30 year has steepened) and what the yield curve does or does not signal about the economy and market performance. Stepping back from the shape of curve debate, there is at least one fact that investors can agree on, the Fed has been hiking rates and we are in a tightening cycle. Cornerstone Macro put together a research paper looking at the last twelve hiking cycles beginning in 1954, to see what happens to the U.S. ISM PMI, S&P 500 earnings growth, and GDP growth. They found that in all twelve cases, the ISM PMI eventually fell below 50, in all but one case (1994) earnings growth turned negative, and in all but three cases (1961, 1983, and 1994) GDP growth was negative. The key takeaway is that regardless of whether the curve inverts at all or does so in a particular fashion, the economy and equity markets have struggled historically during periods of Fed rate hiking.
Revisiting the yield curve shape discussion, Ned Davis Research (NDR) put together a report using the 3-month and 10-year Treasury, which explains what has historically happened to equity returns and economic growth after this curve inverts. Since 1966, the S&P 500 has entered a bear market within 21 months after every (9 instances) inversion of the 3-month and 10-year Treasury. NDR defines a bear market as a 30% drop in the DJIA after 50 calendar days or a 13% decline after 145 calendar days. As mentioned last week when discussing the timing of a recession based on the inversion of the yield curve, the timing of the bear market in relation to when the yield curve inverts is also varied. There were two instances (1989 and 2006) the bear market started over a year after the curve inverted, while in five separate instances, the bear market had already started by the time the yield curve inverted.
Industry positioning may be the most consistent trend during periods of flat and inverted yield curves. Using S&P 500 data, the 5-year beta to the 2- to 10-year Treasury shape is highest for Financials and lowest for Real Estate, Utilities, and Consumer Staples.
When the yield curve flattens or inverts, industries like Real Estate, Utilities, and Consumer Staples tend to outperform Financials. This trend is also true globally as the MSCI ACWI (All Country World Index) Financials has the highest positive correlation to bond yields while Utilities, Real Estate and Consumer Staples have the lowest. This means that as global bond yields have been declining recently, ACWI Financial stocks have also been declining, while Utilities, Real Estate and Consumer Staples have been increasing. NDR also showed that large cap consumer stocks tend to outperform large cap cyclical stocks as the yield curve (AAA Bond Yield-90 Day Commercial Paper) flattens.
Cornerstone Macro has also pointed out similar industry performance trends. Since 1974, Consumer Staples stock returns on a 12-month basis have been positive seven out of eight times following the last Fed rate hike and Utilities have been positive six out of eight times. Cyclical sectors, such as Technology and Materials, have only had positive returns four out of eight times.
While the timing of a large selloff/bear market in overall equity markets or a formal recession are not consistent with the timing of a yield curve inversion, based on how markets have acted historically, it could make sense to become more defensively positioned following a yield curve inversion. As mentioned in prior posts, we have been following this positioning pattern in our portfolios.
Rank Dawson, CFA
Vice President, Strategic Planning
Boyd Watterson Asset Management, LLC
The views expressed herein are presented for informational purposes only and are not intended as a recommendation to invest in any particular asset class or security or as a promise of future performance.