An inverted yield curve indicates a coming economic downturn. Sam Benstead explains what this means for stock markets.
Recessions globally are becoming more likely as interest rates rise, energy costs rocket, and governments withdraw fiscal support following two years propping up households during the pandemic.
Slowing economies will have big impacts on stock and commodity prices, where typically falling GDP correlates with poor returns for commodities and “cyclical” companies sensitive to economic activity, while sectors with reliable earnings could perform better. In turn, this would bode badly for value shares (which tend to be cyclical), which many investors have been snapping up following their resurgence in recent months.
The biggest indicator that economies could shrink comes from looking at the yield on two and 10-year US government bonds.
Typically, investors demand a greater return if they are tying up their money for a longer period. However, when longer-dated bonds yield less than shorter ones, it is taken as a sign by markets that a recession is coming and interest rates will have to come back down to restart the economy.
This is called an “inverted yield curve” and has appeared on and off over the past month. However, it is does not mean that recessions are guaranteed. Experts share their insights on what is in store for the UK economy and those around the world.
Are recessions imminent?
An inverted yield curve is a strong sign that economic growth will reverse for at least six months in a row, the definition of a recession.
Phil Milburn, co-head of the Liontrust global fixed income team, notes that every American recession of the past 50 years has been preceded by an inversion of the US yield curve.
- A tactic to ride out the inflation storm using these funds and trusts
- The investment lessons from the 1970s as inflation soars and rates rise
- Tips for recession-proofing a portfolio: where to start?
He said: “This much-followed market indicator has infamously predicted nine of the last six recessions. Even with the false positives, it is a phenomenon that cannot be ignored.
“If the Federal Reserve rapidly raises interest rates to above 3%, then we think a recession is likely to follow in 12 to 24 months’ time.”
However, he thinks that a recession could be avoided if the US central bank is partly just talking a hawkish game to discourage inflation expectations and pauses at 2% interest rates. In March, the Federal Reserve raised interest rates for the first time since 2018. US rates are now in a target range of 0.25% to 0.5%.
“Then we will expect a ‘soft landing’ of lower inflation and positive growth and the yield curve to start steepening again,” added Milburn.
However, Jim Reid, head of global fundamental credit strategy at Deutsche Bank, has now made a US recession his most likely case. He has downgraded growth forecasts because he thinks higher inflation will require a more aggressive tightening of monetary policy from central banks, pushing the Federal Reserve to reach a 3.6% interest rate by mid-2023.
He said: “With the outlook moving in a more stagflationary (low growth and high inflation) direction, we expect growth to slow materially in the second half of 2023, tipping the US into recession by the end of that year.
“Indeed historically, there’s been just two occasions over the last 70 years when the Federal Reserve has raised rates by 3% and left inflation on a downward trajectory without causing a recession.”
- Bargain Hunter: 10 growth-focused trusts on notable discounts
- Are Scottish Mortgage’s private holdings overvalued?
- Why investors are retreating to passive funds as markets fall
In the UK, Capital Economics’ chief UK economist Paul Dales says the squeeze on household finances is making a recession more likely – but it is still not his most likely case.
From April, energy bills are 54% higher for the typical household, and national insurance contributions are 1.25 percentage points higher, all with inflation at over 6%. Inflation will be a bigger drag on real incomes in 2022 than in any year since records began in 1955, he calculated.
However, Dales adds that the unemployment rate, currently at 3.9%, alongside rising earnings means that households would be able to withstand rising costs.
He said: “That’s why we think consumer spending will continue to rise even as real incomes fall and why, although the risk has grown, there probably won’t be a recession this year.”
How to invest
M&G’s chief investment officer Fabiana Fedeli thinks investors are too complacent after stocks rose in March.
She said: “Moving forward, the key variable to watch will be inflation – what is driving it, and how are central banks responding.”
Fedeli says that in a world of elevated inflation, historically gold and raw materials have performed best.
However, she notes that raw material prices are already elevated at the moment: oil is at its highest level since mid-2008 and commodities are at their most expensive for a decade.
- The top 10 most-purchased ETFs in March 2022
- Is globalisation dead? Top fund managers debate
- Should investors be scared of the big bad yield curve?
“A resolution to the conflict in Ukraine could see a steep decline in commodity prices from current levels,” she said.
The investment chief thinks 2022 will be a very unpredictable year. Faced with binary outcomes, she says there are three key ways investors can protect themselves.
Fedeli said: “Maintain a diversified portfolio. Stay selective and focus on companies that can better deal with cost pressure and have solid balance sheets. Within stocks, favour long-term themes that should continue to prevail, independent of the near-term outcomes. For example, infrastructure and the low-carbon ecosystem.”
Investors should not panic just yet. Darius McDermott, managing director at fund researcher FundCalibre, says that stock markets usually sell off well before a recession hits.
He said: “It doesn't usually pay to try and be too clever. Most investors are better off not worrying too much about the economic cycle and instead investing with a 10 year-plus view.”
When entering a recessionary environment, he said investors usually do well by owning long-dated government bonds.
“This is the natural 'risk off trade'. Investors anticipate that central banks will have to cut interest rates to re-stimulate the economy, which is good for bonds. This worked beautifully in the 2008 financial crisis,” he said.
However, unlike in 2008, there is now a major problem with inflation, which is disastrous for bonds.
He adds: “The risk is stagflation: low growth and high inflation. This is probably the hardest environment to invest in since both stocks and bonds do badly in tandem.”
Two other options, from interactive investor’s Super 60 and ACE 40 lists, are FTF ClearBridge Global Infrastructure Income and FP Foresight Global Real Infrastructure. The former has over 90% direct and indirect exposure to inflation-linked assets, while the latter has 70% of its underlying assets directly linked to inflation, with the remaining 30% indirectly exposed.
- Growth shares versus value shares: the investment styles explained
- A guide on how investors can protect against inflation
McDermott also likes mega-cap, highly profitable tech firms, saying: “These businesses don't have big rising costs from raw materials and we think they can continue to grow. Clearly, big tech is not cheap – but these behemoths certainly look well positioned in these challenging times.
He says those wanting pure technology plays could buy Axa Framlington Global Technology fund or Sanlam Artificial Intelligence. T Rowe Price US Large Cap Growth Equity also owns a lot of technology, according to McDermott.
Gold was a popular investment in March on the interactive investor platform. The iShares Physical Gold ETC moved from third to second place on the most-bought list and the WisdomTree Physical Gold went from 10th to fourth.
These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided by third parties. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.
Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.