The past month hasn’t been Kind to the markets. Global markets have all taken it on the chin. All major indices are negative month to date, Oil is falling, yields are falling and it’s just complete negativity out there.
Deutsche bank tracks 70 asset classes and publishes data going back to 1901. This year a record number of asset classes have posted negative returns.L
Last week another curious phenomenon took place. An inversion in the US yield curve. Now before I explain what an inversion is, let me explain what a yield curve is. Here’s the definition from Wikipedia:
The yield curve is a curve showing several yields or interest rates across different contract lengths (2 month, 2 year, 20 year, etc. …) for a similar debt contract. The curve shows the relation between the (level of the) interest rate (or cost of borrowing) and the time to maturity, known as the “term”, of the debt for a given borrower in a given currency.
Generally it an upward sloping curve with the shortest maturity instruments having low rates and the longer maturities having higher rates, This is because of the risk the investors in the longer maturities securities have to assume.
Last Tuesday the yield of the 5-year treasury fell below that of the 2-year one.
This is not as big a deal because the most watched difference is between the 2 year and 10-year treasuries which also has narrowed quite significantly.
Why is this a big deal?
Historically, all yield curve inversions have been followed by a recession (2 & 10 year). Here’s a graphic from the FT showing the inversions and the recessions
But these recessions don’t occur in a hurry. There is quite a time gap between the inversion and the subsequent downturn.
Source
Here’s an in-depth analysis of the predictive powers of the yield curve.
What does it mean for stock market returns?
The markets really don’t bother about the yield curve. The markets often rally in the time frame between the recession and inversion.
One of the most important insights to be gleaned from the slope of the yield curve is that the degree of the slope indicates the strength of economic growth. Flatter the curve, lower the expectation of strong economic growth. Here’s the US yield curve, as you can see there is a flattening as the curve.
For comparison purposes here’s the Indian yield curve:
Most of this is based on US-specific data. But we live in an interconnected global economy and when the US sneezes, the world catches a cold.
Here’s a really insightful visualization for the Vanguard 2019 market outlook report:
And quote
The concern about an imminent global recession often rests on the assumption that the U.S. expansion— which is among the longest on record—is clearly at the latest stage of the business cycle.
And good for Indian investors!
Return expectations for the next 10 years
The global equity returns acording to the Vangaurd report are in the range of 4.5% to 6.5%. What does this mean for Indian investors? That’s the million dollar question.