Quotidian Investments Monthly Commentary – August 2019
Having started the month on a positive note, global equity markets in the first half of August remained generally benign and the lethargic holiday season effect was evident through a lack of stimulus.
However, on 15th August the mood changed from sublime to ridiculous as we saw the largest one-day decline on the Dow Jones Index since last year’s final quarter market write-downs. The index slid lower throughout that day and the S&P 500 Index and the Nasdaq Composite both closed down about 3%, too. As ever, markets around the world simply followed Wall Street’s lead and the following few days emphasised the markdown even further.
The impetus for this sell-off was suggested to be that the yield on 10-year US Treasury bonds briefly fell below the 2-year bond yield. When shorter-term interest rates exceed longer-term rates it’s known as an inversion of the yield curve (the slope plotting interest rates on Treasuries of different maturity dates).
In general, the opposite alignment is normally true because inflation and default risks over the longer term are deemed to be greater than in the shorter term and those risks are normally then reflected in higher yields on longer dated bonds. When investors demand a higher return to lend for 2 years than for 10 years historical precedent indicates that it has occasionally heralded a recession.
The justification put forward by market-makers in order to validate their eagerness to downgrade equity prices was, therefore, that every recession since the 1950s had been preceded by an inversion of the yield curve. However, that is only a partial truth and represents simplistic not to say lazy (and perhaps self-serving) analysis. What they didn’t make clear was that there have been a multiplicity of yield inversions over this period but not all of them have been a precursor to recession. So, in other words, yes every recession has been preceded by a bond yield inversion (if you wait for long enough) but not every inversion has been the harbinger of a recession.
To make the same point by using a sporting analogy, it is undeniably true that in a game of cricket the scoring of a run is always preceded by a bowler delivering a ball. However, that is as bland and naïve an assertion as the one above and completely ignores the other side of the coin; the fact that not every valid delivery leads to a run being scored. Likewise in the investment world, not every bond yield inversion leads to a recession and the simplistic assertion put forward by market makers to justify their severe markdown on the basis of a very short-term yield inversion does not hold water or stand up to intelligent analysis.
Putting this month’s volatility aside, stocks have actually tended to do quite well following yield curve inversions. In five inversion occurrences since 1978 the S&P 500 has been an average of 13.5% higher a year later according to data compiled by Dow Jones Market Data. The same holds true on average over the two- and three-year periods following an inversion, with the S&P 500 up 14.7% and 16.4% respectively.
Taking just two examples from the past to further illustrate the point: (in 1978) three months after the 2-year/10-year yields inverted the S&P 500 was down over 10% and (in 1980) it was up over 13%. On average, the S&P index has climbed 2.5% in the 90 days after an inversion of that bond pairing.
In their attempts to instil fear into the minds of investors (simply because this stimulates equity activity and so profits the trading house itself) market makers have, by using a brief period of bond yield inversion as their vehicle, tried to create the illusion of inevitability and certainty into an intrinsically uncertain forum (ie. of a forthcoming recession). In fact, this latest yield inversion lasted for a mere 5 days before the 10 year yield overtook that on the 2 year bond again and, as we have seen this month, the short-term implications of this negativity has been another unnecessary markdown in share valuations.
Of course a recession will occur at some point in the future but to suggest that a very short-term bond yield inversion is proof positive that recession is on the near horizon is nonsense. One waits wearily but patiently for the mirage to become apparent (if that’s not a contradiction in terms) and for common sense to revisit equity pricing once more.
On 30th August 2019 the FTSE100 index closed the month at 7207.18, an fall of – 5.00% in the month of August itself and it now stands at + 7.12% for the 2019 calendar year to date. By comparison the Quotidian Fund’s valuation at the same date shows a fall of – 3.20% for the month of August and the Fund is now up + 16.86% for the 2019 year to date.
In addition to the synthetic excitement surrounding bond yield inversion, investors’ fears were stoked with a vengeance by market makers following another round of Donald Trump’s tweets which threatened to impose 10% tariffs on yet a further broad range of consumer goods imported from China into the USA. We clearly recognise that Trump’s negotiation tactics are to wear his opponents down by constant repetition; initially giving the impression that progress has been made only to change tack once more. Raising positive expectations only to dampen and crush them again is a well-trodden path of psychological torture simply intended to weary and weaken the other side in the negotiation.
China’s initial response was to impose fresh tariffs of its own and equity valuations were again hit by negative sentiment. This period of alternating between risk-on/risk-off mentality on a daily basis in stock-markets is as wearing as it is ridiculous but it will come to an end when the inevitable trade deal between China and the USA is finally secured (as it surely will be). Perhaps the Chinese government has belatedly begun to realise that because it announced in the last days of August that it would not now be following through on its subsequent tit-for-tat threats to impose new and additional tariffs.
Stock-markets by their very nature are volatile and that volatility has increased in recent years partly as a by-product of algorithmic (automatic, unthinking and impersonal computer-program’d trading) and partly as a result of fear deliberately initiated by the greed and self-interest of market makers.
Despite the negative month, Quotidian still remains well ahead of its benchmark for the year to date and the reversal of the short-term inversion in bond yields as well as a much more conciliatory tone in the US/China trade negotiations is reflected in more positive sentiment in equity markets as we move into September.