The inversion of the yield curve may be strongly correlated to poor performance in equity markets, but Kames Capital investment manager Colin Dryburgh believes it is too soon to start selling the asset class.
A big talking point among investors at the moment is whether the yield curve – the difference between long-term US Treasury yields and short-term US Treasury yields – will invert in the near future.
An inversion of the yield curve occurs when the long-term yields are lower than short-term yields. The curve has been flattening in recent months and is currently around 30 basis points from inversion.
Historically, it has been an accurate predictor of a recession, which has followed one to two years after a yield curve inversion.
Dryburgh, like many other managers, said the yield curve is one of the leading indicators that he follows when assessing the likelihood of a recession, but unlike some he doesn’t have a negative market outlook.
He said there are two major reasons why investors shouldn’t be selling off equities just yet.
The first is that equity markets tend to perform well in the latter stage of the economic cycle and investors could lose out on potential upside if they sell out too soon.
He said: “[The below chart] shows US equity market returns from the date of each yield curve inversion until the next major equity market peak (purple bar) and the bottom of the subsequent equity market trough (grey bar).
Equity returns from yield curve inversion
Source: Kames Capital
“For example, when the yield curve inverted in January 1989 the eventual market sell-off resulted in US equities still being 9 per cent higher than at the initial date of the yield curve inversion. That’s a lot of upside to give up.
“The equity market’s declines in the early and mid-2000s were much more severe, although investors who bailed-out at the inversion point lost potential upsides of 12 per cent and 26 per cent respectively.”
Although he did admit that calling the top of the market is “notoriously difficult”, Dryburgh believes equity markets still have further to run before the next peak, which is a view he said is supported by both fundamental and technical analysis.
For a number of years now, investors and analysts have been and are continuing to call the end of the expansionary stage in the cycle because a typical cycle will last around seven years.
However, equity markets have rallied strongly since the financial crisis in 2008 and the S&P 500 is still climbing – year-to-date it is up 6.21 per cent.
For those investors looking to go down Dryburgh’s route and time the market to make the most of equity market gains before the asset class starts falling, Chris Iggo, chief investment officer at AXA Investment Managers, said that inflation is the key.
He said: “A lot of Bloomberg TV chat is about the signalling property of an inverted yield curve and what that means for the economic outlook. I think the key is inflation.
“If inflation does not raise any further, then we will get to positive real interest rates a lot sooner than would be the case if inflation was higher.”
He added that inflation is the reason yields are still relatively low and the US 10-year Treasury remains below 3 per cent.
US 10-year Treasury yield year-to-date
Source: Bloomberg
Indeed, the US 10-year Treasury yield has been fluctuating under 3 per cent for most of the year, despite a short stint around May where it rose above the 3 per cent mark.
And in order for the yield curve to steepen, Iggo believes that inflation needs to pick up.
He said: “There is a belief that 10-year yields don’t need to be above 3 per cent because the long-term average short-term rates will be significantly lower than that. So, in this cycle, the only way the curve steepens again from here is if inflation picks up.”
The second reason Kames Capital's Dryburgh advised against selling the risky asset class right now is because the yield curve is still yet to invert.
He said: “[The below chart] shows equity market returns from the yield curve reaching its current level of 0.33 per cent until the next major peak and subsequent trough. Note: This analysis ignores 1993-94, when the yield curve started to steepen and equity markets rallied strongly.”
Equity return from yield curve reaching current level
Source: Kames Capital
In his own fund, Kames Diversified Growth, Dryburgh has a 32.1 per cent allocation to equities, while the largest allocation goes to alternatives where 37.1 per cent is invested alongside 30.2 per cent in fixed income.
Despite not being the largest allocation, he said he remains positive on the asset class: “Our diversified growth strategy will continue to hold a meaningful allocation to equities – for the foreseeable future anyway.
“We allocate through a bespoke global portfolio of stocks which we believe have attractive growth characteristics, but are also of high quality and have good defensive characteristics.”
In the portfolio, which Dryburgh co-manages alongside Robert-Jan van der Mark, the three largest equity holdings are Stoxx Oil Sep18, Syncona Ltd and Insperity Inc.
The fund has returned 16.49 per cent in the past three years, while its benchmark, UK Retail Price Index + 4 per cent, is up 22.05 per cent over the period.