The financial press and many market pundits are focused today on the slight inversion of the yield curve, which means near term maturity treasury bills are yielding more than longer dated issues, most importantly the 10-year note. Historically, an inverted yield curve has often been a precursor of U.S. recessions. The relationship seems logical, due to the fact that when the U.S. Federal Reserve raises short term rates in an effort to control inflation (the Fed does not have the power to alter long-term rates), short term borrowing costs go up, economic activity slows and the economy cools. The best example of this relationship in the recent past is when Paul Volker briefly raised the Federal Funds rate to 20% in June 1981, to tame the 14.8% inflation rate seen in March 1980. This Fed manufactured inversion slowed economic activity and inflation fell dramatically to 3% in 1983 (1).
However, the fact pattern that underlies this historical correlation does not match what is happening today. Longer term yields such as the 10-year treasury yield, are falling to near historic lows, while the Fed is cutting short term rates as inflation remain subdued at under 2%. Thus, the U.S. yield curve is experiencing a dramatic total shift lower, as the Fed cuts short rates and the long end falls as well.
In our opinion, the pressure on 10-year yields, caused by the high demand to buy 10-year treasuries, bears no relation to the past cycles of inverted curves and recessions. The U.S. 10-year note is now a global bond of choice for yield and safety. 10-year buyers are seeking positive yields as opposed to negative yields, most notably on German government bonds. Moreover, we believe that demand for the U.S. 10-year note is also currently driven by international investors seeking safety of capital with yield only a secondary concern, due to geopolitical crises including a potential hard Brexit, Hong Kong civil unrest, and South American economic turmoil in Venezuela and Argentina.
So, in effect, the economic conditions that define the current inversion of the yield curve are incredibly stimulative, since lower long and short term rates historically promote economic growth and higher inflation. As such, we are reticent to blindly react to a historical correlation of an inverted curve and proclaim a recession is imminent.
While we do acknowledge that economic growth from a GDP perspective has slowed somewhat from recent highs, we are of the opinion that the U.S. – China trade conflict is the primary reason for this slowdown. As this is a governmental policy driven slowdown versus a Federal Reserve manufactured rate hike inversion, we believe that any progress to unwinding the trade tariffs and reaching a positive trade deal could come quickly and would be incredibly stimulative to the economy, which is flush with low interest rates and excess liquidity.
So yes, things are different this time. Those are dangerous words in investing. But, in our opinion things are always different from a macro perspective. What is not different, and will not be different, is our discipline to invest in companies with solid balance sheets, that have the ability to grow, and are significantly undervalued against present conditions. We will not alter our valuation parameters to account for business models that will burn cash indefinitely to gain market share, and we will not invest in fundamentally risky business models. We do acknowledge that today’s investment environment is fraught with pockets of high valuations and untested business models, but this is not where we are investing. Our new ideas are entirely consistent with our philosophy and in our opinion represent substantial upside opportunity over the next three to five years.
1. CPI (inflation) sourced the Bureau of Labor Statistics and Fed Funds target rate sourced from the Federal Reserve.
All information contained herein is derived from sources deemed to be reliable but cannot be guaranteed. All economic and performance data is historical and not indicative of future results. All views/opinions expressed in this newsletter are solely those of the author and do not reflect the views/opinions held by Advisory Services Network, LLC. This material is provided as a courtesy and for educational purposes only. Please consult your investment professional, legal or tax advisor for specific information pertaining to your situation