global equity market volatility

Risk of Economic Recession and an Inverted Yield Curve

/ Kiwi Investor / 6 Comments

There has been a lot of discussion recently about the prospect of an inverted US yield curve.  (An inverted yield curve is when longer-term interest rates (e.g. 10 years) are lower than shorter-term interest rates (e.g. 2 years or 3 months).  A normal yield curve is when longer-term-interest rates are higher than shorter-term-interest rates.

Historically an inverted yield curve is a powerful recession sign.  John Williams, who will take over the helm of the New York Federal Reserve Bank of New York in June, said earlier in the year a truly inverted yield curve “is a powerful signal of recessions” that has historically occurred (italics is mine).

The US yield curve spread (difference in yield) between the 2 year and 10 year US Treasury interest rates has recently reached its narrowest in over a decade.  Thus the heightened discussion.

As can be seen in the graph below the US Treasury yield curve inverted before the recessions of 2008, 2000, 1991, and 1981.

It should be noted that the US yield curve has not yet inverted and there is a lag between inversion and recession, on average of 1 to 2 years.  See graph below.  I am not sure I’d call the Yield Curve still “Bullish” all the same.

At the same time, the risk of recession does not currently appear to be a clear and present danger.

Much of the flattening of the current yield curve (i.e. shorter-term interest rates are close to longer-term interest rates) reflects that the US Federal Reserve has increased shorter-term interest rates by over 150 bpts over the last 2 years and longer-term interest rates remain depressed largely due to technical factors.  Albeit, the US 10 year Treasury bond recently trade above 3%, the first time since the start of 2014.  Therefore, the current shape of the US yield curve does make some sense.

Inverted yield curve.png

 

The picking of recession is obviously critical in determining the likely future performance of the sharemarket.

As a rule, sharemarkets generally enter bear markets, falls of greater than 20%, in the event of a recession.

Nevertheless, while a recession is necessary, it is not sufficient for a sharemarket to enter a bear market.

See the graph below, as it notes, since 1957, the S&P 500, a measure of the US sharemarket:

  • three bear markets where “not” associated with a recession; and
  • three recessions happened without a bear market.

bear market recessions.jpg

 

Statistically:

  1. The average Bull Market period has lasted 8.8 years with an average cumulated total return of 461%.
  2. The average Bear Market period lasted 1.3 years with an average loss of -41%
  3. Historically, and on average, equity markets tend not to peak until six months before the start of a recession.

The current US sharemarket bull market passed its 9 year anniversary in March 2018.  The accumulated return is over 300%.

 

Mind you, we have to be careful with averages, I like this quote:

“A stream may have an average depth of five feet, but a traveler wading through it will not make it to the other side if its mid-point is 10 feet deep. Similarly, an overly volatile investing strategy may sink an investor before she gets to reap its anticipated rewards.”

 

Assessing Recession Risk

Importantly, investors should not use the shape of the yield curve as a sole guide as to the likelihood of a recession.

The key forward looking indicators to monitor include an inverted yield curve, but also a significant widening of high yield credit spreads, rising unemployment, and falling future manufacturing orders.

Tightening of financial conditions is also a key indicator, particularly central banks raising interest rates (or reducing the size of their balance sheet as in the current environment) e.g. US Federal Reserve, but also tightening of lending conditions by the large lenders such as the commercial banks to consumers and more particularly businesses.

Lastly, equity market valuation is important.

Happy investing.

 

Please see my Disclosure Statement

US Equity Market 9 Years of Advancement

/ Kiwi Investor / 1 Comment

The US equity market recently celebrated 9 years of advancement without a bear market (a Bear market is defined as an equity market decline of greater than 20% from its peak).

This 9 year Bull market is closing in on the historical record of 9 years and five and half months.  The longest post-war Bull market stretched from 11 October 1990 to 24 March 2000.  To break that record the current Bull market will have to continue until the last week of August 2018.

The US equity market experienced a “correction” in February 2018 (a correction is defined as a fall in market value of between 10 and 20%) on inflation and higher interest rate concerns.  I wrote about this in this blog and also put into historical perspective here and here.  

 

Bull markets end with a Bear market.  Bear markets usually coincide with recession.  Very rarely has there been a Bear Equity Market without recession.  Nevertheless, there have been bear markets without a recession.

Fortunately the global economy has good momentum and recession does not look imminent. Most economic forecasts are for economic growth throughout 2018 and into 2019.

Albeit, the current Bull market does face some risks.  Key amongst those risks are:

  • Earnings disappointment in 2019. Earnings momentum is vulnerable this late in the economic cycle
  • Economic data disappoints – global equity markets are priced for continuation of the current “Goldilocks” economic environment, not too hot and not too cold.
  • Inflation data surprises on the upside
  • Policy mistake by a Central Bank given the extraordinary policy positions over the last 10 years of very low interest rates and Quantitative Easing, e.g. US Reserve Bank needs to raise short term interest rates more quickly than currently anticipated
  • Longer term interest rates rise much higher than currently expected

 

Therefore, lots to consider as the year progresses.

 

I enjoyed this quote from Howard Marks “there are two things I would never say (since they require far more certainty than I consider attainable): “get out” and “it’s time.”  It’s rare for the market pendulum to reach such an extreme that views can properly be black-or-white.  Most markets are far too uncertain and nuanced to permit such unequivocal, sweeping statements.”

Well worth thinking about when making portfolio investment decisions.

 

Please see my Disclosure Statement

Are we in a Bubble?

/ Kiwi Investor / 1 Comment

A developing consensus view is that the US sharemarket is overvalued, certainly by measures such as the Shiller PE (Price to earnings ratio).  Future low returns can be expected based on this measure.

Of course there is some debate about whether this is a bubble. Time will tell.

An earlier Post did touch on this. Another Post put the recent level of sharemarket volatility into a historical context.

 

Furthermore, the consensus view is that although overvalued the risk of a US recession is low. Generally a recession is needed to trigger a large drop in the value of sharemarkets.

None of the following forward indicators are flashing the risk of a recession: Leading Economic Indicators, ISM Manufacturing New Orders, Initial Unemployment Insurance claims, Durable Goods Order, shape of the yield curve (e.g. are longer dated interest rates lower than short dated interest rates, which is often a precursor to recession) and level of High Yield Credit Spreads.

The consensus view is that the US economy will continue to expand in 2018, now into its third longest period of economic expansion. Over time capacity constraints within the economy will grow further (e.g. falling unemployment) and the US Central Bank, US Federal Reserve (Fed), will continue to raise interest rates as the threat of or higher inflation emerge.

This will result in a “classical” ending to the economic cycle where higher interest rates will result in a slowing of economic activity, resulting in a pick-up in unemployment, followed closely by recession, say late 2019 early 2020. Unfortunately the recession will be felt more heavily on Wall Street (e.g. large share price declines) than Main Street.

This article outlines a paper written by James Montier of GMO. He outlines 4 different types of bubbles:

  1. Fad or mania e.g. dot-com bubble, Roaring 20s, and US Housing market
  2. Intrinsic Bubble e.g. Financials prior to the GFC had inflated earnings
  3. Near Rational bubble – the greater fool market, cynical, and they can keep going as long as the music is playing.
  4. Information Bubble

 

Montier argues we are in a cynical bubble (3 above), noting many professional investors acknowledge the US market is expensive yet remain fully invested even overweight, based on a BofA Merrill Lynch survey.

He agrees with Jeremy Grantham, many of the psychological hallmarks of a Fad and Mania are absent. Grantham has raised the prospect the US sharemarket may be entering a two year “melt-up” period as the next phase of the current “bubble”.

Time will indeed tell.  Nevertheless, the cynical bubble appears consistent with the consensus view above.

 

Mortimer’s article also has some great quotes from John Maynard Keynes, a great investor in his own right.

 

 Please see my Disclosure Statement

 

Investment Mistakes to avoid

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In an earlier post we talked about the short volatility (VIX) products that had added to the recent global equity market volatility.

 

The experience of these products prompted a good article from Barry Ritholtz, Five Rules to Help Avoid Investing Disaster.

The Inverse Volatility Products will enter history along-side CDO’s. It is likely that 95% of the wealth invested in these Products will be wiped out when they are finally wound up/terminated.  Well worth following developments here.

 

I am somewhat bewildered from an investment strategy perspective why these exposures would end up in Portfolios at this time. It is a prime example of chasing historical returns. It is always a good idea to be guided by value.  The cost of buying volatility protection was very low. Therefore there was no value shorting market volatility, as these Products did. It is also a good idea to have a counter-cyclical bias in your investment approach: when markets are at historical extremes, i.e. historically low volatility, it is a good idea to reduce the exposure to that market extreme. Markets revert from extremes toward averages – often violently as we have recently witnessed.

This is basis of portfolio risk management and consistent with focusing on managing risk rather than trying to time markets and chase historical returns. I think most of the funds management industry was working out how to go long volatility given the over-brought nature of the global equity markets in January, not short it!  Some form of market correction was widely anticipated, the timing was just unknown.

 

Anyway, ………… the rules outlined to avoid making investment mistakes:

  1. Avoid new products – if they are a good investment no need to hurry – e.g. the Buffet rule in relations to Initial Public Offerings (IPOs)
  2. Learn from history – markets are volatile never get complacent – Hubris before the fall
  3. Never buy anything you don’t understand – another Buffet rule
  4. I would say get good investment advice i.e. wholesale products vs retail product comments, in fact considerable value can be added to client portfolios in this area and costs reduced by accessing appropriate investment strategies not readily available
  5. Greater returns always comes with greater risk – this is a fundamental axiom of investing, never forget it.  If it is too good to be true, it probably is.  There are never “easy” sustainable returns in investing.

 

Happy investing.

 

Please see my Disclosure Statement