When you approach the later stages of the economic cycle, investors try to convince themselves that there is sound logical reasoning behind their bullish or bearish stance. 
While you might hear phrases such as ‘this trade can’t fail’, ‘the market is rational’ and ‘equities always go up’, the most dangerous is ‘this time it’s different’, according to Hermes Investment Management head of investment Eoin Murray.
“There are plenty of words people in investment use to convince themselves – or others – that things are going to be OK. But for me, the worst is: ‘This time it’s different’ Why? Because it invariably isn’t.”
The key area where this is prevalent is in bonds, where people aren’t concerned enough by the flattening of the yield curve and its potential inversion, he said.
Historically, when yield curves have inverted a recession has followed 6-18 months after. As such, investors follow yield curves closely as a reliable predictor of recessions.
Yield curve inversion is when short-term debt instruments are yielding more than long-term debt of the same quality.
Murray (pictured) said: “The yield curve tracks short and long-term interest rates that fuel the traditional banking model.
“Short-term rates are usually lower, so it is cheaper for banks to take deposits, and the longer-term rates are higher, so they can issue loans and take a turn on the difference.
“Any disruption to this system sees the model break down. An inversion of the yield curve occurs when short-term interest rates are higher than long-term ones.”
Some of the most common ways to measure the yield curve is by looking at the difference in yield between the US 10-year Treasury and the US 2-year Treasury or between the US 30-year Treasury and the US 3-month Treasury.
Predictive power of different term spreads
Source: Federal Reserve Bank of San Francisco, Hermes Investment Management
While both yield curves have been flattening for some time and the direction of travel points only to further inversion, they are still yet to invert. The 10-year and 2-year yield curve is currently 24 basis points from inversion and the 30-year and 3-month yields are 103 basis points apart.
However, Murray said that other versions of the yield curve have already inverted, meaning “it may be too late” for those already worried about the yield curve inverting.
He said: “Setting aside the nominal yield curve and looking at the real one, calculated by discounting breakeven inflation at each point of the curve, it inverted earlier this summer.”
Other yield curves that have already inverted include the corporate yield curve, and Murray said that corporate bonds are trading at a slight premium to government bonds.
He added that a global recession could be coming our way because the global nominal yield curve has inverted.
If the signs are pointing to a recession in the near future, then what should we expect from investors?
The Hermes head of investment said: “For investors, the anticipated economic malaise associated with a recession can easily erode wider confidence and tends to push down risk assets.
“Investors also abandon higher-yielding but less sound investments that seemed attractive in good times, favouring a flight-to-quality approach.
“In credit markets, investors should expect to see covenant weakness exposed, as defaults mount and recovery rates fall from the current relatively high bar. So, what can investors do?”
Nominal vs real yield curve (10yrs-2yrs)
Source: Bloomberg, Hermes Investment Management
In terms of which assets perform better during down markets, Murray said history would suggest there are a number of areas investors can turn to.
One of these is the property sector, where equities and fixed income instruments that are linked to “renovation activity” instead of new builds should fare better.
Elsewhere, he said utilities and consumer staples generally outperform in recessionary environments.
“Quality earnings and long-term cash flows become even more valuable, and hint at companies less likely to default,” said Murray.
“And there will always be opportunities for savvy, long-term investors to pick up the debt stock in good businesses that become undervalued.”
Nevertheless, the head of investment doesn’t necessarily believe that a recession is imminent and can see some reasons why we might manage to avoid one.
One such reason is that earnings around the world are still strong at the moment despite the rise of protectionism and deglobalisation.
And he said that, although the two main yield curve indicators are edging closer (10-year vs 2-year and 30-year vs 3-month), they are yet to invert. And it is their inversion that is the predictor or a recession, not their flattening.
Murray added that one of the counter theories for the lack of concern about the yield curve inverting is the reason why long-term interest rates may be falling.
He said this argument suggests that the “dynamics” of quantitative easing might be reducing the term premium part of long-term interest rate yields, meaning that this part of the yield curve is not a concern.
Corporate yield curve
Source: Bank of America Merrill Lynch, Hermes Investment Management
But Murray is not convinced by this: “There is sufficient uncertainty around the effects of QE on interest rates that there really is no clear empirical evidence to suggest that ‘this time it’s different’.
“At the same time, in the US, the Fed is raising short term rates as its economy improves – inflation (core PCE has at last reached the magical 2 per cent and earnings are accelerating beyond a comfort zone). So why is nobody concerned about this potential inversion?”
He concluded that although he couldn’t say for sure whether it would be different this time, not thinking about the possibility that it might not be different is a big risk to take.