Yield curve inversions as a timing tool?
Last week I wrote about the financial media’s habit of hyping a yield curve inversion as a harbinger of doom. But as an evidence-based investor, I wonder if that hype about the yield curve inversion is justified in the short run. In the medium to long run I am firmly in the camp that the current yield curve inversion in the US signals a recession and possibly an equity bear market, but I wonder if this bear market necessarily starts today?
In order to check how useful the yield curve inversion in the US is as a stock market timing tool, I checked the price return of the S&P 500 in the six months after the events I used last week. Due to a lack of data availability for industry indices, I used only yield curve inversions since 1989.
The average return of the S&P 500 in the six months following a yield curve inversion was +2.1%, quite a bit below the long-term average return of any six-month period but still positive. However, the last three yield curve inversions in 2000, 2006 and 2007 were all followed by declines in the S&P 500. Whether this is because these yield curve inversions came at the peak of massive stock market bubbles, because of the rise of investotainment media, or for some other reason, is impossible to tell. However, a yield curve inversion has been followed by negative stock market returns more often than not in recent decades.
This does not necessarily mean that one should sell all stocks, though. Sector and industry performance can vary dramatically, depending on the interest rate sensitivity of the underlying businesses. As an example, I have calculated the six-month returns for the S&P 500 Banks, Diversified Financials and Insurance industry groups. Banks tend to suffer when the yield curve inverts since their business model is fundamentally driven by maturity transformation (i.e. borrowing at short maturities and lending at long maturities). If the yield curve flattens or even inverts, margins get squeezed and bank stocks start to suffer. Insurance companies, on the other hand, tend to hold a lot of long-dated bonds in their portfolios to match the duration of their insurance contracts. This is particularly pronounced for life insurance companies. Declining long-term interest rates are a boon for the valuation of their investment portfolios and thus for the valuation of their businesses.
Diversified financials tend to be a mix of all kinds of businesses, with brokerage firms historically the most prominent members of this industry group. However, since the financial crisis, most of these brokerage firms have been converted into banks, which affects the performance of the diversified financials group going forward. The historically strong performance of the diversified financial group as shown in our chart below is unlikely to repeat itself this time around since Goldman Sachs is the only major brokerage firm left in this industry group. Because brokerage firms tended to benefit from the higher stock market volatility in the aftermath of a yield curve inversion through increased trading profits, these companies have been historically the drivers of the outsized returns of diversified financials. Today, this industry group is dominated by major asset management firms like Blackrock, which track the overall S&P 500 more closely than brokerage firms do.
What this exercise tells us, though, is that it is time to assess the investments in an equity portfolio and increase the “duration” of the equity holdings, i.e. focus more on industries and businesses that are sensitive to declining long-term rates and reduce holdings in industries and companies that are more geared towards growth or short-term interest rates.
Performance of financials after a yield curve inversion
Source: Bloomberg, Fidante Capital.