Seeking Alpha
Recommended for you:
Bonds, dividend investing, ETF investing, long only
Profile| Send Message|
( followers)  

The yield curve — the spread between short and long-term interest rates — has turned upside down, or “inverted,” in both India and Brazil at various times of late. In the past, that has been a harbinger of recessions or bear markets. It’s far from a perfect indicator — what is? — but when it happens, attention must be paid. If an inverted yield curve takes hold in both those countries and spreads to others, that would signify trouble. Emerging markets would certainly be hit, and we wouldn’t be immune, either, as some of the world’s largest multinationals do more and more business in those fast growing countries.

The yield curve tracks the spread between two- or three-year Treasury notes on the short end and the 10-year note on the long side and their equivalents in other countries. Most of the time, long rates are much higher than short rates because bond investors demand higher rates to compensate for the long-run risk of inflation. The US Treasury yield curve is comfortably steep now.

But occasionally, short-term rates top long-term rates because either bond investors think the economy is so weak that they don’t see much inflation ahead, or the threat of inflation pushes the central bank to raise short-term rates above long-term rates.

In any event, the inverted yield curve usually means a weak economy. When short-term rates rise, borrowing money becomes much more expensive and businesses don’t expand, or they might even cut back. That’s how tight monetary policies lead to recessions and bear markets.

Since the early 1950s, a yield-curve inversion has preceded all but one official recession, according to academic research cited by Vanguard. And since 1960, the Treasury yield curve has inverted 13 times, anticipating 10 bear markets. The following chart from the Federal Reserve Bank of Cleveland tells the tale.

[Click to enlarge]

chart
“Practitioners take this seriously. Traders use it, too. That’s why the stock market tends to reset so quickly to changes in the yield curve,” said Deborah Weir, a Wall Street veteran and instructor at the New York Institute of Finance who wrote extensively about the yield curve in her 2005 book Timing the Market.

“It’s very rare that you get a period of equity return [outperformance] following an inverted yield curve,” says Richard Bernstein, chief executive officer of New York-based Richard Bernstein Advisors LLC.

You might remember Bernstein from the days when he cut a distinctly independent profile amid the thundering herd at Merrill Lynch, where he served as chief investment strategist. He’s still contrarian in spirit, this time about emerging markets, on which he has been bearish for some time. In April, he wrote a commentary in the Financial Times warning that they were where the real inflationary pressures lay.

He says the money supply in some of these countries is growing at a 15% to 25% annual clip, versus a below-average 6% growth in M2 here. He’s definitely not in the US hyperinflation fantasyland inhabited by Dr. Marc Faber and Peter Schiff.

When inflation is high (it’s above 6% in emerging markets, double what it is in developed countries), central banks hike short rates quickly. They have done so several times in India, Brazil, and China. That can cause the yield curve to invert, and bring on recession and bear markets.

Measured in local currency values, Brazil and India “are very, very close” to yield curve inversion, Bernstein said. “India and Brazil are at the point where they’re fish on the deck flopping around.”

Their stock-market performance reflects that. Brazil is off 19% in US dollar terms so far in 2011, while India has lost 12.5%. The US, with our jobless pseudo-recovery and dysfunctional politics, is just about even, based on the performance of the S&P 500 index through Wednesday. In fact, the broader MSCI emerging-market index is off 4.2% this year in dollar terms and has fallen 7.4% in the local currencies.

Bernstein pointed out that “the S&P has been outperforming BRICs for the last three and a half years,” although the broader emerging-markets index is slightly ahead of the S&P for that period. Yet US investors loathe US equities with a passion while they are still true believers in emerging markets. Obviously, they buy the fallacious argument that faster GDP growth yields better stock-market returns.

According to the Investment Company Institute, US investors pulled an astonishing $344 billion out of domestic stock funds from 2007 through June 2011. During that same period, they poured a net $68 billion into emerging-market funds.

“People are gaga over countries where the yield curves are inverting,” said Bernstein. “When the yield curve inverts, the rate of profit growth turns negative. It’s never failed.”

That probably means big bear markets ahead in some of these countries; I’ve argued that China is actually in a secular bear market. But US investors are far too caught up in a narrative of American decline to notice.
Also, if we get full yield curve inversions in more emerging markets, that could lead to slower growth in countries that are supposed to be the world’s economic engine. The International Monetary Fund looks for 6.5% annual GDP growth in emerging markets this year and next.

Any slowdown in that would be bad, bad news, especially for multinational companies that do a lot of business in emerging markets, such as 3M (NYSE:MMM) and Emerson Electric (NYSE:EMR). And it could take US exporters by surprise, too, hurting our economy.

But it would be good for companies that are domestically focused, primarily smaller and mid-cap stocks, said Bernstein, who has focused the portfolios he manages on companies that had below-average exposure to emerging markets.

I part ways with Bernstein on this one. I’m not a big fan of small caps now; I think they’ve already had their big run. But I haven’t been in emerging-market stocks for quite some time, either.

Generally, investors should have some of their portfolio in emerging markets, but don’t look on them as a panacea — especially if the yield curve in some of these countries is beginning to flash red. That way madness lies, as King Lear said.

Source: Red Flag for Emerging Markets - And Us