Inversion and the Art of Portfolio Management
Contributed by Doug Walters, Max Berkovich, David Lemire
This week, inversion was the buzzword (see our Headline of the Week). On Thursday, the spread between the 2-year and 10-year treasuries turned negative. The yield curve was officially inverted. Financial media outlets predictably pounced on this event with headlines of an impending recession. After all, an inverted yield curve is the best predictor of a recession…Right?
Not so fast. While it is true that if you plot the 2/10 yield spread and recessions, you will notice that many recessions are preceded by a yield curve inversion. But this is no timing mechanism and a great case study on how damaging market timing can be. A couple of S&P 500 statistics from the past 25 years put this into perspective.
- 20 months: the median time between inversion and the US stock market peak
- 29%: the median total return of the US stock market from inversion to market peak
Market timing once again proves a lousy strategy. Historically, those exiting the market on inversion would have missed out on huge upside in the subsequent months. Will the same trends happen this time? Not necessarily. Investors are better off preparing with a well-diversified portfolio rather than trying to predict the unknowable.
It is also probably worth reminding investors why the yield curve is inverted. The US economy is hot! The job market is buoyant; unemployment is low; GDP is strong. But the hot economy and supply chain challenges are driving up inflation. The Fed is taking its foot off the gas by raising interest rates and eliminating its bond purchases. Raising the Fed Funds Rate disproportionately puts upward pressure on shorter duration treasuries (like the 2-year), leading to inversion. So inversion itself is not inherently bad. Much depends on whether the Fed is getting the timing right on its actions.
Are you still concerned about a recession? Rest easy with a well-diversified portfolio. Rather than trying to time the market’s reaction to a US recession, ensure your portfolio does not have too much home bias. The equity portions of our strategies hold a healthy allocation to developed international and emerging markets. Take this week, for example. While the S&P 500 was flat over the past seven days, the MSCI Emerging Markets index was up closer to 2%!
US Stocks (S&P 500) ended the week nearly flat. International and Emerging Markets stocks fared better, with the latter (MSCI EM) up around 1.8%. Geopolitical turmoil remained top of mind, and investors absorbed some big economic data points. The “jobs” number (non-farm payrolls) was generally in line with expectations, with 431K jobs created. Unemployment ticked lower to 3.6%. But it was the yield curve inversion that garnered the most attention.
Inversion Excursion
On Thursday, the 2-year and 10-year spread inverted. This move occurs when yields on the 2-year are greater than the 10-year. Inversions are unusual as investors are typically rewarded with higher yields for investing in more risky, longer-dated treasuries.
- The 5-year/30-year spread was also inverted this week.
- The 2/10 inversion is the first since August 2019, while the 5/30 inversion has not occurred since 2006.
- Inversions are often viewed as recession signals, prompting many articles to highlight the risk.
- There are complicated dynamics in place, with the Fed trying to unwind the pandemic stimulus. If they get it right, a recession is not a forgone conclusion.
- Judging by the limited reaction by stock investors, a significant policy mistake is not anticipated.
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