Global stocks have rebounded in the past couple of weeks, recovering more than half the losses suffered from the start of the year until mid-March. The primary driver of the recovery is expectations of an agreement to end the Russia-Ukraine conflict. This also explains the sharp pullback in crude oil prices and the reversal in the broad USD, with the EUR being the main beneficiary. The market moves show how the Ukraine conflict is influencing short-term asset prices. Nevertheless, a key bond market indicator is signalling concerns about growth. Given this, how should investors position from here?
Since the start of the conflict that, as long as the Ukraine conflict does not lead to a halt in Russia’s energy exports, the medium-term path for financial assets is likely to depend on the longevity of the current economic/business cycle. The US recession monitor comes in handy here – while most indicators still point to a sustained economic recovery over the next 6-12 months, some consumer confidence indicators have started to flag warning signs amid heightened concerns about inflation.
This week, a key gauge has flashed another warning sign: the US 10-year government bond yield dipped below the 2-year yield for the first time in the post-COVID-19 recovery, indicating investors are concerned that the Fed is likely to tighten short-term interest rates (represented by the 2-year yield) too much as it sets out to tackle inflation, causing growth (represented by the 10-year yield) to slow sharply. Since the 10-year vs 2-year curve has inverted before every recession in the past 50 years, the latest inversion has understandably raised concerns about an impending recession and the end of the equity bull market (since recessions are usually accompanied by equity bear markets).
These concerns are believed to be premature. A review of asset class performance after the inversion of the Treasury yield curve over the past 50 years provides several reasons to believe the current business cycle has further to run and why it is too early to pull the trigger on downgrading equities:
First, not all yield curves have inverted. Indeed, the 10-year vs 3-month yield curve, which has been a timelier (and hence more useful) predictor of recessions vs the 10-year vs 2-year curve, has steepened this year. Historically, on average, this curve inverted six months before US stocks peaked. Second, history shows US stocks continued to rise and comprehensively outperform bonds for months after the 10y-2y yield curve first inverted. On average, equities peaked 12 months after the curve inversion, rising an average of 18% over the period (with gains ranging 8%-34% until peak). Third, a recession started an average of 14 months after a yield curve inversion. Fourth, US financial conditions remain extremely easy today – real rates are deeply negative, unlike the past when they averaged 200 bps when the yield curve inverted; this is also reflected in the Fed’s policy rate, which, at 0.5%, is well below its estimated 2.4% ‘neutral’ rate. Fifth, bank lending conditions are easing; US banks are well capitalised, which should support continued credit expansion. Sixth, corporate bond yield spreads are still historically tight, despite recent widening.
Finally, fundamental data remains strong – US initial jobless claims are close to their lowest since 1969, the US jobless rate is still declining (we are watching the upcoming payrolls data) and business confidence indicators, especially new orders PMIs, are all expansionary.
The above factors lead to believe that equities are likely to outperform bonds in the next 6-12 months. Sectors to look out for are the financial sector, which is likely to benefit from rising rate expectations; the market is now factoring in 50bps rate hikes each at the Fed’s May and June meetings as inflation continues to surprise on the upside in the near term due to higher energy prices. Energy sector equities, another preferred area, have lagged the oil price rebound by c.50% over the last five years and we see an opportunity for this gap to narrow. The preference within the energy sector lies within the following sub-sectors: integrated oil companies, producers, service providers, and transporters.
