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Weekly Insights
Volume 11, Edition 12 | March 28 – April 1, 2022

Inversion and the Art of Portfolio Management

Doug Walters, CFA
Treasury yields inverted this week, stoking fears that a recession could be on the horizon. Should investors be worried?

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%!

Headline of the Week

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.

The Week Ahead

It will be a slow week on the Economic front next week; however, there are plenty of headlines to be made.

At the Bank

The Reserve Bank of Australia (RBA) and Reserve Bank of India (RBI) have rate decisions next week.

  • RBA isn’t ready to join the party. Although the economy has recovered from the pandemic, Australia has much lower inflation readings.
  • While not ready to hike, markets expect Australia to join other developed nations and hike rates in June.
  • For now, Australia is a commodity exporter benefiting from the boom in commodity prices.
  • The RBI is also expected to stay put on rates at this meeting.
  • India faces a sluggish economy and is in no rush to remove accommodations. However, inflation is running hot and may force them to rethink that view.

A Page-Turner…

Both the European Central Bank (ECB) and the Federal Reserve (Fed) will release minutes of their last policy meeting.

  • The Fed raised rates by 0.25% at the last meeting, but markets expect 0.5% at the next meeting in May.
  • Any color around what the Fed needs to see to dial that down will be of paramount interest.
  • The ECB is not raising rates yet, but the minutes of their meeting will be perused for guidance of taper of its asset purchase program.
  • The ECB intends to taper first before hiking rates.

Service Please!

Next week, the US economic data calendar is light, with the Institute for Supply Management (ISM) release of the non-manufacturing Purchasing Managers Index (PMI) being the highlight.

  • The Services activity composite gets a boost as the post-Covid demand for travel and Hospitality should push the March numbers up a few points to 58.
  • The above 50 reading and an increase for March should reinforce the strong consumer story. However, a negative development will undoubtedly fuel the economic slowdown camp.
  • The PMI reading has fallen sharply from 68.4 in November, which was an all-time high.

March Madness Ends In April

The NCAA Basketball tournament comes to an end with the Final Four teams.

  • Saturday, Villanova will face Kansas, and ACC rivals North Carolina will face Duke for a spot in the National Championship on Monday.

Holy Month

Saturday is the start of Ramadan, the holy month of fasting, introspection, and prayer for Muslims.

  • Ramadan celebrates the month when the holy book Quran was revealed to the Prophet Mohammad.
  • To those observing: Ramadan Mubarak!.

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