Is it time to get out of the market?
If you’ve been following business news this year, you’ve probably seen the headlines warning that a recession is near. One of the reasons is because the yield curve has inverted for the first time since July 2007. An inverted yield curve has been one of the most accurate predictors of an upcoming recession. In fact, over the last 60 years, an inverted yield curve has preceded every US recession. That said, the yield curve has also inverted a couple times without a near term recession occurring, so an inverted yield curve is a good predictor, but not perfect. The bigger question is, should investors head for the sidelines?
What is a yield curve?
The yield curve plots the interest rates one can expect if buying bonds of varying maturities. Think of buying a GIC; you would receive different quotes for 1 to 5 years and you would expect a higher rate for the longer maturity GICs since they lock up your money for longer. A normal yield curve is upward sloping, which means that investors will receive a higher interest rate for buying longer-term bonds.
The yield curve in a growing economy
When the economy is doing well, the yield curve will usually look like a normal climbing curve, as shown above. If the economy is doing too well, central banks will raise short-term interest rates in order to keep inflation in check. As the central banks do this, it’s typical for investors to expect slower growth in the future. This is because businesses and individuals will pay more interest on their loans, leading to less money being spent on goods and services in the economy. When this happens, we tend to see a slowing of economic activity, and possibly even a recession.
Investors anticipating this higher risk might sell things like equities and buy safer investments like bonds. The additional demand for bonds doesn’t affect the short maturities as much since the rate is set by the central banks, but the central banks have less control over longer-maturity interest rates. This can result in central banks raising short-term interest rates and long-term interest rates moving up less or even declining due to the additional demand. Recall that there is an inverse relationship between bond prices and interest rates. That scenario is essentially what happened in the US in 2003 and 2006.
The economy isn’t the stock market
The stock market is forward looking and unreliable at forecasting recessions. How would an investor’s portfolio have performed in the five years that follow a yield curve inversion with heightened anticipation of a recession?
In every one of these instances a recession happened at some point within 5 years of the yield curve inverting. There were declines in the stock market, but the timing of the onset thereof was inconsistent. Some declines occurred right away (2000), some declines took a couple of years to materialize (1998 and 2006), and somewhat surprisingly, at other times the markets barely declined at all (1978 and 1989).
Notably, an investor would have experienced positive returns four times out of five with a 100 percent equity portfolio five years after the initial inversion. In the case of a 60/40 Balanced Portfolio (60 percent in stocks and 40 percent in bonds), the investor would have been positive after five years in all five recent US inversion scenarios.
What does this mean?
History might have demonstrated a clear connection between an inverted yield curve and recessions, but there is nothing conclusive about the timing of subsequent recessions. The charts above demonstrate that longer-term investors were not adversely impacted in a pronounced manner, in most cases, and that balanced investors fared better than those with all-equity portfolios.
Taken in tandem with the fact that market timing is exceptionally difficult, this should give investors reason to pause before exiting the markets. Even though an inverted yield curve tells us a recession might be coming, we don't know when or have any sense of its potential magnitude. Recession fears will spark an emotional reaction for many investors, but investment decisions should be long-term focused and made within the context of a well-defined investment plan. Staying on plan through all phases of a market cycle will generally pave the way for a superior long-term outcome. We acknowledge that this might sound counterintuitive, but staying invested for the long term is generally the most effective strategy.