The yield curve has inverted and you should sell your stocks. That is a simple, declarative statement, and yet one that I have not read anywhere this morning. Having awakened to the news that the yield on the 2-year U.S. Treasury note had risen above that on the 10-year U.S. Treasury note, I have enjoyed this morning's sell-off in the equity markets. I founded a new asset management firm, Excelsior Capital Partners, a month ago to initiate short positions on stocks, and so far the timing has worked out well.
There seems to be a basic misunderstanding of the meaning of the inverted yield curve and its meaning for equity markets. I am making a few bucks on this confusion, to be sure, but I would rather see an educated investing public. Some of the articles I have read this morning in the financial media are wildly misleading. So here are a few answers to basic questions:
What is an inverted yield curve? The yield spread is a simple calculation that involves subtracting short-term interest rates from long-term interest rates. The yield curve is a plot of interest rates for government bonds of all maturities in a given country. Bond yields represent, in percentage terms, the price investors are willing to pay for those securities. When demand for bond purchases rises, prices rise, and thus yields (interest rates) fall. When long-term bond yields are lower than short-term yields, the spread is negative and the yield curve is inverted.
Money has a time value. A dollar today should always be worth more than a dollar tomorrow. I think most investors grab that basic fact. There's a second derivative there, however. At most times in economic history, a dollar two days from now has been worth more than tomorrow's dollar, which is worth more than today's dollar. Similarly, a dollar a year from now is worth more than that two-day dollar and the dollar five years from now is worth more than the dollar one year from now, and on and on and on. If I am lending you a dollar for five years not five days, I want an extra incentive to do that. Five years gives you much more time to default on that loan, plus—in a concept known as duration among bond investors—there is a much larger chance that the interest a lender will earn over a longer time period can be rendered less valuable by inflation, always the biggest factor impacting bond pricing.
The rate of inflation in the U.S. probably won't change much in three months. In ten years, though, it could show a marked difference. The Federal Reserve and other central banks have consistently referred to the fear of deflationary pressures as the biggest worry facing financial markets. This morning's bond markets are telling you that inflation is going to be much much lower in 2029 than it is in 2019.
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That is the key meaning of an inverted yield curve. Inflation expectations for future periods are lower and that can only mean a slowing, and perhaps contracting, global economy. Stocks are valued based on growth, and the colossi that are Amazon, Facebook, Netflix, etc. have all been built on rapid rates of growth in revenues and earnings. If the bond market is telling us the global economy is slowing, the stock market should price in lower rates of growth for individual stocks. That is why shares of those tech titans—and the vast majority of stocks around the globe--are falling sharply today.
Isn't lower inflation a good thing? If it costs me less to buy things outright and lower interest rates also result in lower costs to finance purchases made over time (house, car, etc.) how is that a bad thing? Simply put, it's not a bad thing for consumers. At the same time it is a horrible, terrible, awful thing for financial institutions such as banks. If it costs a bank more to finance the money underlying a loan than the interest that bank can earn on the loan, the bank would take a loss on that loan. Obviously bankers are not stupid, and loan growth can be expected to decline when short-term funding costs are higher than long-term loan prices.
The global economy in 2019 is based on access to credit, and it has been for the past 50 years. This is what we should have learned from 2008. Jamie Dimon’s balance sheet at JPMorgan is much more important than the one based on your household's financial situation. I am sorry if that offends you from a political standpoint, but please do not misunderstand. There have been zero real changes in policy or statute since 2008 that would change that. If credit conditions dry up, we could just easily see a meltdown in 2019 as we did in 2008-2009. These are basic facts, not conspiracy theories or political slogans.
For the past 10 years, naysayers have been calling for another global financial crisis and yet my stock portfolio has gone up, up, up...what is different now? The biggest development in the world economy over the past decade has been the astounding growth of the financial system in China. China’s economy, which was barely dented by the financial crisis that ravaged Western economies in 2008-2009, is now, ten years later, just as dependent on credit as that of the U.S. and in fact more so, by certain measures. The Chinese only really embraced state-sponsored capitalism in the early 1990s and it took them 20 years to embrace the concept of leverage. But, man, have they done it in a big way.
In December 2008 the total assets of the Chinese financial system were $9.1 trillion. That compared to $12.2 trillion in U.S. financial system assets. As of June 30, 2018, the latest data available, Chinese financial system assets totaled $39.0 trillion dwarfing the U.S.’ total of $17.5 trillion. So, the Chinese financial system has more than quadrupled in the past decade. Does that worry you? It should.
That’s why pictures of protestors occupying the airport in Hong Kong are so scary. That’s why the Chinese government's decision to let the yuan/dollar exchange rate rise above 7:1 (making Chinese financial assets worth less in dollar terms) is so scary. That’s why President Trump’s trade tweets can and will move the markets significantly—in either direction. Anything that makes Chinese companies less likely to repay their loans is a decided negative for global bond markets. Each of those three factors certainly qualifies.
That’s also why the yield curve in the U.S. has inverted. Any measure of U.S. current economic activity or financial system liquidity looks fine or even better than fine. But the bond market looks like the world is in the middle of a global catastrophe. Why? Because global markets are interlinked.
You can’t just sit in Peoria, Illinois and say the fact that Danish banks like Jyske are now offering negative rates on 30-year mortgages doesn’t affect you. It does. Some financial institution you use will have exposure to European bonds and when those bonds mature refunding them at negative rates is going to lead to losses. You can’t just sit in Rexmont, Pennsylvania and say that the fact that assets in China’s financial system now represent more than half of the world’s GDP doesn’t concern you. If you have a 401k, it damn well should.
So, wake up, smell the coffee and lessen your holdings of equities. The bond market and its inverted yield curve are telling you that economic growth is slowing—or perhaps even contracting. The valuation of stocks, above all else, depends on estimates for rates of earnings growth. Anyone who is telling you “don’t panic” or “you can’t time the market” is a complete buffoon and should be ignored. That includes many of the talking heads on CNBC, by the way.
Selling stocks into an economic downturn isn’t panic, it is just smart investing. Practice it.
