CAPTRUST Chief Investment Officer
On March 22, a relatively unusual thing happened within the U.S. bond market. The yield on 3-month Treasury bills closed higher than the yield on 10-year Treasury notes. Said another way, on that day, an investor was willing to accept a lower yield on a bond with a maturity of 10 years than on one with a maturity of just 90 days. The yield curve, the plot of bond yields for bonds across a range of maturities, is normally an upward-sloping line, as investors typically demand higher interest-rate compensation—or yield—for longer-maturity bonds. But on March 22, and for the following four trading days, this curve inverted.
The event caught the attention of investors and was widely reported in the financial press, because an inverted yield curve can be interpreted as a sign that the future economic outlook is weak, creating a stronger appetite for safe haven assets such as Treasury bonds. On the day the curve inverted, the S&P 500 Index of U.S. large-cap stocks paused its exceptional run-up from year end to decline by 1.9 percent, before resuming its advance a few days later when the yield curve inversion reversed.
Investor psychology aside, historical precedent also suggests that yield curve inversions can signal trouble ahead for the economy—and for stock prices. An inversion of the yield curve has preceded every recession for the past six decades, providing strong evidence that it is a signal worth paying attention to.
However, inverted yield curves do not cause recessions. Nor do they imply that a market selloff is imminent. The truth is more complicated.
The Yield Curve as Policy Tool
The Federal Reserve, as the U.S. central bank, seeks to promote the economy’s effective operation through its use of monetary policy tools. One of its most powerful tools is the ability to set the discount rate—the interest rate charged to commercial banks for short-term loans necessary to maintain its required reserves. When this rate is lower, banks are encouraged to lend, an expansionary policy that stimulates the economy. Conversely, a higher discount rate makes it more expensive for banks to borrow funds. This tighter policy stance tends to constrict lending and dampen growth.
Because the discount rate is a very short-term interest rate, the Fed’s influence on the “short end” of the yield curve is greater than its influence on intermediate- or long-term bond yields. Although longer maturity yields are influenced by short-term rates, other market factors outside of the Fed’s control also play a major role, including investors’ outlooks for inflation and economic growth and supply-and-demand dynamics. When investors become afraid of riskier assets (such as stocks) and seek out Treasury bonds as safe haven assets, this greater demand for bonds pushes bond prices higher and pulls yields down.
Although the Fed doesn’t have complete control of the yield curve, it has significant influence over its level and shape, which it can use as a tool to change policy or influence behavior. This tool can be thought of as a hammer that can tamp down unhealthy excesses within the economy—like a monetary policy version of the amusement park game Whack-a-Mole. Categories of excesses that can be tamped down in this manner include:
- High inflation—perhaps triggered by rising commodity prices or wages;
- Growth in risky lending; and
- Asset price bubbles—such as past run-ups we have seen in stocks and home prices.
Figure One looks at the last four yield curve inversions, the presence of these excesses at those times, and the policy action taken by the Fed to combat them.
Figure One: Presence of Unhealthy Excesses within the Economy and Action Taken by the Fed
Source: CAPTRUST Research
Although a recession followed each of the four periods above when the yield curve inverted, other significant factors also played a role, leading us to believe that, absent other forces, the recent—and very brief—curve inversion does not portend a near-term recession. Today, we do not see disturbing levels within any of these categories of excesses. And while the yield curve did briefly invert in March, we view it as a consequence of the Fed’s desire to return to a normal level of interest rates after a period of extraordinary low rates and a means to increase its room to maneuver in the future.
Yield Curve Inversions and Stock Prices
Even with the presence of excesses outlined in Figure One, stock market returns can remain positive for some time after a yield curve inversion occurs. In fact, following the past 11 yield curve inversions—which takes us back to 1960—stock prices, as measured by the S&P 500 Index, had risen one year later in most cases.
Figure Two: S&P 500 Returns One Year after Yield Curve Inversion (Since 1960)
While these odds (six of 11, or 55 percent) for positive one-year returns are not as high as we typically see for stocks—on average, the S&P 500 has shown a positive return in 73 percent of one-year periods—they still lie in the investor’s favor and don’t imply that a stock market decline is a foregone conclusion. What is striking about the data in Figure Two is that, while an inverted yield curve does not always mean a near-term market selloff is ahead, it does signal that something significant—positive or negative—may happen over the next 12 months. In only two instances were the 12-month forward returns in the single digits.
Action and Reaction
It is important to remember that policy isn’t set in a vacuum. The dramatic stock market selloff in late 2018—particularly the 26 percent decline in Chinese stock prices and 20 percent decline in U.S. stock prices, and the yield curve inversion earlier this year—captured the attention of world leaders and policymakers, chiefly among them, the U.S. and Chinese presidents and the Fed chairman. All three parties reacted with quick and decisive action to boost investor confidence.
It is useful to revisit how we arrived at this point. 2018 started with a boom, as the Tax Cuts and Jobs Act reduced corporate tax rates and increased take-home pay for most taxpayers. Higher after-tax income boosted consumer confidence and retail spending, while higher business confidence unleashed additional corporate reinvestment or capital expenditures. As Figure Three details, corporate reinvestment by S&P 500 firms grew by nearly 12 percent in 2018.
Figure Three: Increase in Corporate Reinvestment by S&P 500 Firms
Over the course of the year, the tone of trade discussions between the U.S. and China deteriorated, dealing a blow to business confidence as U.S. firms grew concerned with their ability to conduct business with their global trading partners. When the U.S. introduced tariffs on Chinese exports, confidence deteriorated further.
As we entered the fourth quarter, the state of global growth began to weigh more heavily on the markets. While the U.S. had very strong growth in 2018, growth in the rest of the world was already slowing, particularly in China following a crackdown on risky lending practices, and in Europe, a region that had not demonstrated much growth since the last recession and now finds itself grappling with an increasingly messy Brexit.
These factors, combined with the perceived lack of flexibility on the part of the Fed, culminated in steep price declines in risk assets, such as stocks, in late 2018. The stock market sell-off was too significant for policymakers to ignore. With the presidential election calendar in the U.S. and the need for continued growth to maintain political stability in China, politicians opted to give in to these market signals, and the tone of trade discussions improved.
We also witnessed a dramatic change in the Fed’s tone. During its December meeting, Chairman Powell commented that the central bank’s balance sheet wind-down was on autopilot. Just a few weeks later, the Fed announced a pause in its plan to increase short-term interest rates and an early end to its balance sheet runoff program. These actions served to reduce intermediate- and long-term interest rates, with mortgage rates declining from near 5 percent to 4 percent. U.S. stock prices roared back, returning 14 percent since year-end.
Looking ahead, we are focused on the resolution of U.S.-China trade negotiations and a rebound in global growth. A signed trade deal would reduce levels of geopolitical risk, provide a boost to business confidence, and spur investment.
Efforts toward economic stimulus in China may be beginning to bear fruit, as evidenced in Figure Four, by improvement in Purchasing Managers’ Index levels, an indicator of business conditions for manufacturing and service sectors. A stronger Chinese economy would also benefit other emerging market countries, as correlations between these economies and China are very high.
Europe, on the other hand, continues to face both a weak economic backdrop and political division, with resolution of the Brexit impasse once again delayed.
Figure Four: Caixin China Manufacturing Purchasing Managers’ Index (Seasonally Adjusted)
We expect U.S. corporate earnings will disappoint for the next several quarters before showing signs of improvement in the fall. A reduction in earnings expectations provides room for an earnings surprise to the upside—although this is not what we expect.
Following a steep decline and a dramatic recovery, U.S. stock valuations, as measured by the price-to-earnings (P/E) ratios of stocks of the S&P 500 Index, are fair, with P/E ratios very close to their 25-year average. However, if history is any indication, very short-term price action could disappoint. While we have enjoyed a near-record three-month return in 2019’s first quarter, history shows that stock prices typically weaken in the three months following such significant rallies.
We believe the Tax Cuts and Jobs Act will provide a bit more stimulus to individuals this year than last, although the benefits will accrue more to lower-income earners and less to the highest-income earners in high-tax states. While we expect corporate capital expenditures to slow from their double-digit growth in 2018, business investment could continue at a level that supports economic expansion. We are also mindful that productivity is beginning to improve, jobs remain plentiful, and housing should receive a small boost from lower mortgage rates.
Grading the Curve
Does this mean we are ignoring the yield curve inversion? Not at all. The yield curve’s shape provides useful information, particularly when coupled with other forces in the economy, such as the levels of growth and inflation.
Historically, the signaling strength of a yield curve inversion has been greatest when accompanied by a fed funds interest rate that exceeds the growth rate of nominal gross domestic product (GDP). Our analysis shows that when both events occur, the economy may be very near to a recession—and the paired inversions are also accompanied by quick action by the Fed to cut interest rates, as shown in Figure Five. For example, in the 1973 to 1975 period, by the time both the yield curve and the fed funds/GDP curve inverted, the Fed was already four months into rate-cutting mode.
Figure Five: How Many Months Did It Take the Fed to Ease Interest Rates after a Yield Curve Inversion?
With the fed funds rate at 2.5 percent and nominal GDP growth rate at approximately 5 percent, we believe there is still breathing room before this relationship turns, and some of the positive stories from 2018 could propel the U.S. economy further in 2019. Yet even with all the positives cited above, we believe that most of the outstanding uncertainties would need to be resolved in our favor to push stock prices meaningfully higher from here.