Is the Treasury Yield Curve a Crystal Ball?
Sources: Sources for data in tables: Equity Market and Fixed Income returns are from JP Morgan as of 12/07/18. Rates and Economic Calendar Data from Bloomberg as of 12/10/18. International developed markets measured by the MSCI EAFE Index, emerging markets measured by the MSCI EM Index. Sector performance is measured using GICS methodology.
Concerns over trade, Brexit, and the first signs of an inverted Treasury yield curve sent equity markets into a vicious tailspin as the S&P 500 Index retreated 4.55%, settling at a level of 2633, while the Russell Midcap Index fell 4.35% last week. Additionally, the Russell 2000 Index, a measure of the Nation’s smallest publicly traded firms, receded by 5.53% over the course of the week. On the international equities front, developed markets lost 2.25%, while emerging market equities gave up 1.33%. Finally, the 10-year U.S. Treasury yield fell substantially, settling at a level of 2.85%, as investors took a risk-off stance and flocked to the perceived safety of U.S. Treasuries.
Last week started off on a fairly hopeful foot as investors continued to enjoy the residual floor that promising G-20 trade discussions between China and the U.S. provided. However, sentiment quickly reversed course following a string of pro-tariff tweets by President Trump. The ensuing selloff in global equity markets intensified as the first signs of an inverted Treasury yield curve (specifically between the 2 and 5-year Treasury in this case) began to materialize. Many believe that an inverted yield curve (typically between the 3-month and 10-year Treasury) is a foolproof sign of impeding recession. On the other hand, many argue that the shape of the yield curve has been distorted from hefty asset purchases by global central banks in the aftermath of the Great Recession, and such distortion has detracted from the curves predicative power. Let’s momentarily discount this argument, and take a look at the Treasury yield curve through a historical lens.
Our research into the Treasury yield curve and its reliability as a predictor of near term recession suggests that it has been a dependable leading indicator, not a coincident indicator. In other words, an inverted yield curve typically proceeds an economic recession, not by days or weeks, but by months or years. In fact, on average the yield curve inverted 20 months prior to the start of the last seven recessions, and equity markets averaged a 19% growth rate over that time frame. Investors that fled to safety at the first signs of yield curve inversion might miss out on some of the strongest returns each respective bull market cycle has to offer. According to J.P. Morgan Asset Management, “the average return for the two years preceding a downturn is almost 45%; even for six months preceding, that return averages 14%.”
To provide another perspective on current recession forecasts, the Cleveland Fed’s recession indicator, which measures the chances of an economic decline over the next 12 months, currently stands at 20%. So, rather than overreact and abandon equity exposure, or capital markets altogether, investors would be wise to revisit the diversification that may, or may not, be in place within their existing portfolios and update (or complete) their longer term financial plans as appropriate. A strategic asset allocation strategy tailored to one’s specific longer term financial plan can help provide comfort to investors during periods of intensified market volatility. If you would like to learn more about how we are helping clients invest dynamically and consistently with their own goals, timeframe and tolerance for risk, please do not hesitate to speak with your Hennion & Walsh Financial Adviser.
Disclosures: Past performance does not guarantee future results. We have taken this information from sources that we believe to be reliable and accurate. Hennion & Walsh cannot guarantee the accuracy of said information and cannot be held liable. This information is provided for informational purposes only and is not a solicitation to buy or sell any of the asset classes or sectors discussed.
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