The yield curve is top of the agenda as the year draws to a close, but there may also be opportunities in amongst the risks facing investment portfolios this December and looking ahead.
Expert Investment News:
The inversion of the US yield curve sparks recession concerns
Volatility ahead augurs value opportunities
Private lending and market-neutral hedge funds prove their worth
Bear market fears warrant closer inspection
A buying opportunity in Asian equities and other markets set to emerge
Professional managers ponder the right response to volatility
Featuring this month’s experts:
1. December’s US “yield curve” shock
The “yield curve” is a key investor gauge of the outlook for an economy – and in early December days the US yield curve has performed in a way which is traditionally perceived as negative.
In normal market conditions, it should cost less to borrow money for shorter periods, such as two years, than it should for longer periods such as ten. This is partly because of the potential impact of inflation on the fixed returns of a bond over time: investors want compensation for the extra risk. As a result, shorter-dated government bonds usually have a lower yield than longer-dated ones.
An “inverted yield curve” occurs when shorter-dated bonds yield more than longer-dated bonds and indicates that investors expect falling interest rates, lower inflation and slower economic growth – in other words, a recession
An inverted yield curve has preceded every economic recession in the US since the Second World War. It is understandable why the shift has sparked anxiety.
How concerned should investors be? It is important to recognise that an inverted yield curve is a leading indicator. While it may warn of slower future growth, it does not reflect the present state of the economy. Indeed, since 1950, the average time lag between the yield curve inverting and the economy subsequently slipping into recession is calculated at 19 months. During those periods the S&P500 has risen by up to 21%.
Chief Investment Officer at Cazenove Capital
2. Volatility to create value opportunities
In 17 of the past 20 years the FTSE 100 has finished December higher than it began it. Will this year be one of the exceptions? Brexit and trade wars saw the FTSE drop nearly 7% during the first week of the month.
Something else at play was the flattening yield curve. The yield curve plots bond yields of varying maturities. While many theories seek to explain its shape, we can presume that under “normal” conditions the longest-dated bonds offer a higher reward than their short-dated equivalents because they do not mature till later – perhaps much later – by which time a return that looks attractive in today’s low-inflation, low-interest-rate environment may be unappealing.
When an economy is growing strongly and investor confidence is high, the yield curve tends to reflect this with a more sharply upward slope, embodying the expectation that interest rates and inflation will rise in the future; the yield curve can tell us a great deal about investors’ predictions of the economy’s direction of travel.
It is a reminder that markets are still largely driven by humans and therefore prone to mood swings and bouts of irrationality
This month the yield curve flattened, which is often viewed as a sign of investor anxiety. The big worry is that it will actually invert – a portent of every US recession since 1945.
We are experiencing mixed emotions – seasonal joie de vivre, which usually drives markets up, and end-of-cycle anxiety, driving them down.
It is a reminder that markets are still largely driven by humans and therefore prone to mood swings and bouts of irrationality. The resulting volatility should create opportunities for active investors.
Assistant Portfolio Manager at James Hambro & Partners
3. What’s the lifespan of a bear?
Investors endured another difficult month in November. US equities retested their October lows, while the FTSE 100 bumped along the 7,000 level before another fall in early December. Many are now wondering how long this will last, with markets having something of a Groundhog Day feel about them.
At present, we do not believe we are at the start of another bear market. Global economic growth prospects remain respectable, albeit a little weaker at the margin, and there is some evidence coming through that China’s extra support for its economy is beginning to bear fruit. While there has been quite a bit of commentary around the yield curve inverting (where long-term yields fall below short-term yields), and how this signals a recession, it normally operates with a lag of eighteen months to two years and with interest rates as low as they are, it is not a cast iron guarantee that recession is forthcoming.
Even if the bear is upon us, we’re already about a quarter of the way through the average length, and we would need to see signs of a recession now
Nevertheless, I did take a look at previous bear markets to see what investors might be in for, and how long they typically last. Since 1945, the average peak to trough decline of a bear market in US equities has been around 34%, with this typically taking 395 days to play out. The longest bear market was the unwinding of the dotcom bubble at the turn of the millennium, with that lasting just under three years. The shortest, starting in August 1957, lasted a mere 56 days.
Of course, we don’t yet know whether we are in a bear market. On a positive note, markets are already discounting plenty of bad news with valuations on equities now at a discount to their 20-year averages. US and UK equities have corrected by about 10% from their recent highs from September; this is a pullback rather than a bear market for now. Even if the bear is upon us, we’re already about a quarter of the way through the average length, and we would need to see signs of a recession now. While Brexit might lead the UK economy into a recession, there are no signs of that for the global economy.
Investment Manager at Quilter Cheviot
4. Burgeoning buying opportunities in the year ahead?
Trying to predict the future is always hard and at this time it appears harder than ever. Interestingly, the wider consensus is now getting worried about economic growth in the year ahead and highlighting some of the negative trends recently exhibited in financial markets. While people are not necessarily wrong to be getting nervous, the time to take that view was in 2017 and be proactive rather than reactive about a challenging year for markets in 2018. Whilst economic growth next year seems set to be lower than previously imagined around the world, investors would be wise to recognise that asset markets are usually good at sniffing out and pricing in future growth disappointments and the collapse we have seen in UK, Asian and European share markets this year have surely priced in at least some of the economic slowdown we are seeing right now and into next year. Indeed, we believe we are approaching a buying opportunity in Asian equities and other markets could also be getting to cheap valuation levels for long-term investors.
Some of the pricing of bonds in the recent turbulence has become nonsensical and allows nimble investors outsized rewards
Indeed, even the much-hated UK equity market could offer up a surprising experience in 2019, particularly if there is a further deterioration in sentiment over our chaotic exit from the European Union. It might well be that you wait until the lorries start backing up on the M20 to get the cheapest prices, but with UK equities distrusted by most global investors and approaching historically cheap absolute and relative valuations, investors should not throw the towel in on their UK investments. In the UK’s credit markets there is also a “Brexit” premium that investors can take advantage of in high-quality corporate bonds. Indeed, some of the pricing of bonds in the recent turbulence has become nonsensical and allows nimble investors outsized rewards. My advice for what appears a tricky year ahead is ignore the noise, focus on valuations and take a contrarian approach.
Chief Investment Officer at Psigma Investment Management
5. Portfolio positioning
The markets have become more volatile in the last few weeks and it is hard to see an end to the uncertainty anytime soon. Too many questions regarding major political and economic events remain unanswered. The current sell-off is either a great time to buy and add to positions that are now at a discount, or it is the beginning of a new trend, and we should sell while we can.
There is no crystal ball that will help us make that decision, but in fact, this is not a decision we actually have to make. Positioning your portfolio depending on a macroeconomic view or, worse, in a way to time the markets is utter folly. The markets are always doing something, but the thing is we don’t always know what and we certainly can’t predict when.
The way to structure your portfolio is so that you can get rewarded for the risks you take, while making sure you don’t have too much invested in any one particular risk
The way to structure your portfolio is so that you can get rewarded for the risks you take, while making sure you don’t have too much invested in any one particular risk (which is why you don’t want to take a view). If the investments across your portfolio are truly different (in terms of risks, not assets), then something will always be working regardless of what happens in the markets. This allows you to rebalance and buy in when things are cheap and over time that has always been the best strategy of all.
Chief Investment Officer at Blu Family Office
6. The big investment trends coming down the track
As concerns heighten over Brexit, a potential trade war, the Fed pushing interest rates up and the technology cycle, the markets will continue to be mired in pessimism, until they have some clarity on what might happen. In these uncertain times, what do we think will be the “big things” in 2019?
FAANGs to CRAABs: FAANGs (Facebook, Apple, Amazon, Netflix and Google) are yesterday’s technology and we think the tech of the future – and therefore the investment opportunities – are in cryptocurrency, robotics, artificial intelligence, automation and biotech. So CRAABs are in our net for 2019.
Convertible bonds: When interest rates creep up and equities are climbing “a wall of worry”, convertible bonds – a fixed-rate instrument that can convert into shares at a specific share price – are worth a look. Convertibles have an equity correlation and can move with the underlying share price, but also have a “bond floor” (a price below which they can’t fall). This hybrid makeup means they are a flexible and attractive investment vehicle.
When interest rates creep up and equities are climbing “a wall of worry”, convertible bonds – a fixed-rate instrument that can convert into shares at a specific share price – are worth a look
Japan: Japan is making a comeback. From an investment point of view, Japanese valuations are much cheaper than their US counterparts. And their dividend paying ratio is excellent – again, much better than the US. All of this has been underpinned by Prime Minister Shinzo Abe’s “three arrows” approach to economic and corporate reform, with a focus on return on equity and shareholder friendliness.
Fixed income – back in vogue? Corporate and government bonds have been out of fashion for years but we’re starting to see a shift. When bonds are providing a return of 2% or less, the rule of thumb is to leave well alone. When US treasuries start to return more than 3%, they will be on our radar.
Chief Investment Officer at Canaccord Genuity Wealth Management
The investment strategy explanations contained in this piece are for informational purposes only, represent the views of individual institutions, and are not intended in any way as financial or investment advice. Any comment on specific securities should not be interpreted as investment research or advice, solicitation or recommendations to buy or sell a particular security.
We always advise consultation with a professional before making any investment decisions.
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