The last few weeks have been chaotic for the stock market. August was particularly challenging, with 3 days of U.S. market single-day declines of 2.5% or more — one of those days was August 14. On that day, the two-year treasury yield rose above the 10-year yield (a yield curve inversion) and was interpreted by many as a sign that a recession is on the horizon.
The media had a heyday with the news — stories of doom and gloom dominated the headlines. There were two key questions raised by many investors. Because there is enough drama in the financial markets these days, I’ll cut to the chase early for those who can’t take the suspense:
1. Is there going to be a recession? Possibly.
2. Is it time to sell stocks? No.
Let’s dive into deeper explanations below:
What is a yield curve inversion?
A yield curve inversion occurs when short-term interest rates are higher than long-term interest rates. Under “normal” market conditions, the yield curve is upward-sloping, with longer-dated bonds offering investors more return than shorter-term bonds. This is because investors usually demand a higher return to lock their money up for longer.
When the yield curve inverts and short-term interest rates are higher than long-term rates, the expectation is that interest rates are likely to be lower in the future. This could happen because economic growth is expected to be lower in the future. Hence, the fears that an inverted yield curve is a sign that a recession is imminent.
Is there going to be a recession?
Historically, a yield curve inversion has sometimes (but not always) preceded recessions. This time, there are reasons to believe that there is something else at play with this inversion.
With $15 trillion plus of negative yielding bonds around the world, higher yields within the U.S. are a draw for foreign investors, and this demand is thought to be pushing yields lower. This — combined with some worrying numbers indicating a slowdown in growth from Germany, China and Singapore — could help to explain last week’s inversion.
According to Janet Yellen (former Federal Reserve Chairwoman), “There are a number of factors other than market expectations about the future path of interest rates that are pushing down long-term yields.”1 Yellen is not the only former Fed chairperson who has expressed this view. Per Alan Greenspan, “There is international arbitrage going on in the bond market that is helping drive long-term Treasury yields lower.”2
While U.S. economic growth has certainly slowed down this year, the U.S. consumer continues to be in a strong place. Unemployment is at a low of 3.7%, and wage growth is a solid 3.2%. Recall that consumption accounts for over two-thirds of U.S. GDP.
Is it time to sell stocks?
You may be thinking that if we have this indicator of recessions flashing red, then maybe it’s not a bad idea to sell stocks. While intuitively that might seem to be the right step, the research shows that making this type of change to your portfolio is detrimental.
Even when an inverted yield curve precedes a recession, the timing of when the recession occurs can vary. Additionally, stock market movements don’t track economic growth; this makes it very difficult to successfully time decisions of when to move into and out of stocks based on changes in the economy.
A recent paper by economists Ken French and Eugene Fama examined data going back to 1975 across 11 major stock and bond markets to determine if an inverted yield curve predicts the stock market underperforming short-term Treasury bills (a substitute for cash).
They compared the returns over the next one-, two-, three- and five-year periods between a strategy of staying invested in stocks and a strategy of switching from stocks to cash when the yield curve inverted. They found no evidence that inverted yield curves predict stocks will underperform Treasury bills.3 In other words, switching to cash when the yield curve inverted would have made investors worse off than staying invested in a stock portfolio.
Looking toward the future
None of us have a crystal ball to perfectly orchestrate decisions of when to move in and out of the stock market. In the absence of a crystal ball, using time-tested research to guide the decision-making process and maintaining discipline in a well-conceived approach are the best tools a long-term investor has.
At Wipfli Financial Advisors, we’re committed to keeping you updated on trends, events and issues such as these, and providing guidance to help you meet long-term success.
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