Don't Panic Because The Yield Curve Inverted, Focus On The Big U.S. Macro Picture Instead

|
Includes: SPY
by: Angel Martin Oro
Summary

The probability of a US recession has skyrocketed, according to several metrics. This is partly due to the inversion of the yield curve, which historically has preceded recessions.

Should investors panic because of this? My answer, and that of recent data research, says no.

Instead, we should carefully analyze the state of the US economy by taking a broad look at its main areas such as employment, investment, consumption, housing and money trends.

After doing this, we have concluded it's very unlikely a recession is imminent.

We find no evidence that yield curve inversions can help investors avoid poor stock returns.

This is a quote from the last summary section of the recently published study titled, “Inverted Yield Curve and Expected Stock Returns,” which was written by two well-known finance professors, Nobel Laureate Eugene F. Fama and Kenneth R. French.

The statistics analysis, which I found via Ben Carlson’s blog, analyzes data since 1975 for 11 stock and bond markets to find out if an inverted yield curve, as it is incipiently at present, can help predict market behavior and, thus, be an alpha source for investors. In particular, they compare different types of strategies, the passive or buy-and-hold method that does nothing - as if the investor were not watching financial TV or reading the media outlets - and various active strategies that try to take advantage of the curve signal by rotating out of stocks and into bonds. They do this for subsequent periods of one, two, three and five years.

The conclusion, in a nutshell, is well summarized by the quote above. They found no evidence that the inversion of the yield curve predicted that stocks will underperform Treasury bills (used as a cash proxy) in the following years. In the vast majority of cases in the study (67 out of 72, or 93%), the "active" strategy did worse than the buy-and-hold strategy. This is what they write in the final summary:

The simplest interpretation of the negative active premiums we observe is that yield curves do not forecast the equity premium. This interpretation implies that investors who try to increase their expected return by shifting from stock to bills after inversions just sacrifice the reliably positive unconditional expected equity premium.

This is just one more study on the usefulness (or lack thereof) of the yield curve signal for investors. I don’t want to argue here that it’s a useless indicator, but that the market and the media may be too focused here.

On the one hand, even if we knew for certain that a recession is coming, we would not know when it would hit. And even if we knew that, we wouldn’t know when the stock market would peak. The relationship between the stock market and the economy is complex, and reflexivity and other issues play a role.

Furthermore, the truth is that we don’t even know whether the yield curve’s informational power is still good enough, as some economists such as the chief economic advisor at Allianz, Mohamed El-Erian, have argued.

Data even suggests that markets tend to rally after the yield curve inverts, marking the final euphoric stage of the bull market:

Source: Urban Carmel

So taking advantage of the yield curve sign - provided that this time is not different - boils down to getting timing right, which is never easy. Try it at your own peril.

What I suggest doing instead of obsessing on the yield curve, and what I will touch upon below briefly, is that you should try to paint yourself a reliable and broad picture of the US economy. Here we will take a look at different sectors and areas of the economy, including but not limited to:

- Weekly unemployment claims (employment). They are at/near all-time lows. As we can see below, to foresee an imminent recession, we should start seeing an uptick in unemployment claims. We don’t see that. It looks like it might be bottoming out, but I’m not smart enough to predict an uptick going forward.

- Private investment, quarterly data (investment). Investment is actually the most volatile part of the economy, much more than consumption is. Thus, it leads business cycles and, thus, it’s more important to watch as a business cycle indicator than consumer trends. Below we can see how investment is performing decently, growing at stable annual rates at the moment. I can’t see anything odd or negative there. Sure, this is not a leading indicator, but it’s common to see a declining trend before the recession hits.

- Retail sales (consumption). There is nothing to add here but stable growth.

- Private housing building permits (housing). This is a relevant and leading indicator of the business cycle (see Ed Leamer’s work “Housing Is the Business Cycle”). This looks worse than the previous charts, and it is something to watch closely. But it seems to me it’s too early for alarm signs to ring loud. Take into account that the steep fall in bond yields might have a positive effect on mortgage and housing demand.

- Narrow money supply in the US (money). As the below chart shows, in contrast to what happened before previous recessions started, we are now seeing a rising money trend.

Source: Simon Ward

All in all, despite the evident US economy slowdown, the yield curve inversion shouldn’t make investors panic. Does it mean it should be ignored? No, perhaps at this point of the cycle we should be more cautious, or at least, aware of potential risks out there. For that purpose, I feel watching the broad indicators I displayed above is more important. With this evidence in hand, I find it very bold to talk about a recession being imminent.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.