Pictet AM: Inverse rentecurve voorbode vlakke aandelenmarkt VS

Mar 25, 2019

What does it mean for investors?

We are entering the last phase of the market and business cycle (the yield curve is a proxy for the output gap) and a major market peak (and a US recession) is likely in the next 12-24 months.

First of all let me say that contrary to conventional wisdom, there is no evidence whatsoever that the yield curve has lost is predictive power because of quantitative easing or of the exceptionally long (and weak) business cycle. This time is not different. It never is. The yield curve continues to be a great “live” indicator of where we are in the business cycle, which in turn means it is a reliable indicator of future economic growth and equity returns.

The inversion of the US yield curve points to a significant deceleration in US economic growth (by 1.5/2 percentage points over the next 5 years, implying an average real GDP growth of about 0.5-1% on average).

A simple rule is the following: US real GDP growth in next 5 years = US real GDP growth over past 5 years + 1.5* (US 10Y – US 2Y yield) – 2% = 2.5% + 0% – 2% = 0.5% - which is roughly 1 percentage point below most estimates of trend growth, pointing to significant downside risks for the US economy.

US Equities will struggle to post even positive real returns over the next 5 years (historically, a 100bps flatter curve implies a c 10% p.a. lower return for equities over the next 5 years; the 10bps spread between US 10Y and 2Y is consistent with a c10% lower annual return of US equities from current level, i.e. 1% total return, which in turn means that the S&P500 could be in 5 years’ time at roughly the same level of now.

Additionally, the flatter yield curve clearly points to a much more volatile market environment over the next 2 years, with the implied volatility of US stocks (VIX index) rising c50% to ~30 against a long-term average of 15-20.

Overall, and in any investment horizon, US equities perform much better when the yield curve is steep but over a 6-12 months period the gap is not statistically significant. Over a 6-12 month investment horizon, the direction is much more important than the level of the yield curve: equities perform 3 times better when the curve is flattening relative to when it is steepening. Bonds perform much better than average in any investment horizon when the yield curve is steepening.

But on a tactical basis, say 3 to 12 months, an inversion of the US yield curve is not terrifying at all. The US 10Y/3M curve first inverted in December 1978, May 1989, September 1998 and February 2006 ... well before a market peak and on average 1.5 years before the start of a US recession – which has always marked the beginning of an equity bear market. S&P rallies on average c30% from the forst inversion date to market peak according to UBS calculations. Historically, the business cycle ends when US short rates > US bond yields ~ US nominal GDP growth ~ US Earnings yield but with ongoing financial repression (i.e. real rate well below real GDP growth) the second part of the equation may not hold true anymore.

Bottom line: it is the right time to reduce the equity exposure strategically and to increase the exposure to defensive asset classes and sectors. On a tactical basis, though, nothing has changed: a cyclical equity overshoot is still possible if growth surprises on the upside this year and/or the Fed turns excessively dovish.