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Implications of an Inverting Yield Curve

Aug 19, 2019

“Be a loner. That gives you time to wonder, to search for the truth, have holy curiosity. Make your life worth living.” – Albert Einstein

The yield curve has inverted, and a long hibernating bear woke up this week, as conditions are starting to look decidedly gloomy. Marc Faber, aka Dr Doom was back, suggesting investors start accumulating gold.

U.S. Yield Curve Inversion Begins Countdown to a U.S. Recession

The inversion of the U.S. yield curve is a warning, and the entire financial and non-financial world has by now read about it. We wonder what implications this will have on consumer confidence. Since the 1950s, it has taken between eight and 24 months for a U.S. recession to start after a yield curve inversion. The average and median length of time from inversion to the start of a recession are 15.1 and 16.3 months, respectively. This would place the start of the recession at November 2020. But…it’s not quite as simple as that.

More importantly, for the same data set, the S&P 500 topped out within approximately three months of the inversion six times (1956, 1959, 1965, 1973, 1980, and 2000). For the other four instances, the S&P 500 took 11 to 22 months to peak (1967, 1978, 1989, and 2005). Looking from 1990, two of three instances are in the longer time bucket.

Yield Curves are Flattening Globally

Globally, yield curves have inverted or flattened in the U.K., Germany, Japan, Singapore and Australia. Germany, U.K., South Korea, Argentina, Brazil, Mexico and Singapore look to be headed into recession. Since the inversion is supported by evidence of slowing growth, turmoil, the signal can no longer be discounted. The countdown has started on the last leg of the U.S. economic expansion.

The U.S. Treasury Bond 10 Year – 2 Year Spread Has of Late Been a Fairly Early Indicator for Recessions…

The U.S. Treasury Bond 10 Year – 2 Year Spread Has of Late Been a Fairly Early Indicator for Recessions…

Inversions Have Also Been Generally Well in Advance of Market Peaks, Except in 2000

Inversions Have Also Been Generally Well in Advance of Market Peaks, Except in 2000

Normally U.S. Corporate Bond Spreads Over U.S. Fed Funds Spike in Advance of Recessions…
…We’re Not Seeing That Yet

Normally U.S. Corporate Bond Spreads Over U.S. Fed Funds Spike in Advance of Recessions We’re Not Seeing That Yet

NSimilarly Steepening in the 10 Year – 3 Month Spread is an Efficient Indicator As Well

Similarly Steepening in the 10 Year – 3 Month Spread is an Efficient Indicator As Well

Brent’s Decline from $74 to $58 Is Likely to Keep Inflation in Check, Help the Fiscal

Brent’s Decline from $74 to $58 Is Likely to Keep Inflation in Check, Help the Fiscal

Global Chaos and Unrest Is Rising

Alongside the slowdown, and possibly because of it, the world is witnessing a rise in disorder and chaos. Hong Kong is raging against China, the U.S. is witnessing an alarming rise in crime and unrest, Europe is at war with immigration, Pakistan and India are tussling over Kashmir, the U.S. is imposing sanctions on Iran, waging a trade war with China and Mexico. North Korea is busy launching missiles and no one cares. Argentina looks like a depression could be headed there. Venezuela is probably in the throes of a depression and tensions are ongoing in the middle east.

But, Global Stimulus is on the Way

Japan’s Cabinet on Friday approved 5.05 trillion yen ($61 billion) in new economic stimulus. Expectations are that the European Central Bank president will announce on Thursday that the institution’s bond-buying program will be extended by six months at the current 80 billion euros ($85 billion) a month. India is looking at an economic package to rejuvenate growth. Der Spiegel magazine reported that Germany’s right-left coalition government would be prepared to ditch its balanced budget rule and take on new debt to counter a possible recession. China has announced various stimulus measures. There are strong expectations that the U.S. Fed will come forward with QE.

Crude Oil Prices Are in a Bear Market Again

A shot in the arm for India and oil importers, as well as for global inflation, is the decline in crude oil, which now sits at $58.6, a much-needed respite from the $74 level it reached in late April. That is a 21% drop in crude oil prices from the recent peak, and will keep import inflation in check, will reduce inflation domestically, aid the fiscal deficit and give the oil marketing companies a profit windfall.

Are We in a Bubble Environment Like 2000 and 2007?

2000 was a widespread global bubble in technology stocks. 2007 was a widespread bubble in real estate and stocks globally. As we look at our markets, we don’t see a bubble. In the U.S. and Europe, there is a bubble in debt securities and negative interest rates seem to be a clear indication of excess and mispricing.

The acceleration lower in U.S. treasury bonds and the actions of participants suggest that developed bond markets could be in bubble like conditions. In absolutely no fundamental normal economic environment should an investor be paid to take on debt. It is irrational, and bubbles are by nature, irrational. Selling to the greater fool never ends well.


All Eyes on the Finance Ministry

Our domestic markets avoided a 3% down day on Thursday, courtesy of it being a holiday, and the sense is that the impending news of a stimulus package is holding the fort. If the government can come forward with a credible spending package, India will fare better. Should the government disappoint, then India is likely to be one of the prime candidates for further selling.

The Credit Crisis & Rising Interest Costs are Biting into Earnings

Every conversation we are having with clients of late has been decidedly pessimistic. The mood shifted post budget. Some clients are stating that they are hearing how bad it is, but it isn’t that bad in their own business. This also comes through in the earnings data. Top line sales are up 10% with two thirds companies reporting, and operating profits are near the same number as well. So, the economy is not as bad as it looks. It is interest costs that are biting, having soared by 22% during the first quarter ended June 2019, and decimating profits.

India’s Services Sector Exports Have Shown a Pickup

Latest trade data are demonstrating a marked pickup in services exports. This coincides with a recent article in the Economist praising India’s services capabilities. Services exports have expanded 8.65% during Q2 CY2019 to $74.0 billion, while merchandise exports contracted marginally by 0.37% to $107.4 billion.

Exclude petroleum and gems and jewellery, and services exports are now almost the same as merchandise exports. Job losses are fewer in the services sector than among manufacturers. Further, there are fewer firms in service industries being dragged into bankruptcy. FIRE – Finance, Insurance, Real estate and Information Technology are leading contributors.


Asset Allocation & Key Considerations

Asset allocation is shaping up yet again to be the most important predictor of returns looking ahead. To be clear, we aren’t predicting a recession; rather, prudent investment strategy today is to recognize risks and opportunities and being prepared for multiple outcomes.

There are a few key issues to consider as we look ahead:

• One, the yield curve prediction is generally early, so it could be 15 months before a market peak, or as little as three months. That is a wide spread. In the last 25 years, there have been a couple of instances where a recession did not unfold post an inversion, but we got the Asian currency crisis and sharp selloff in 2006 instead, both sharp sell offs. So, the track record has held up since 1980.
• Second, global central banks are announcing stimulus packages, so the severity of the slowdown is difficult to gauge.
• On the other hand, President Trump cannot afford a recession in 2020 and has already demonstrated he will buckle to market pressure (S&P 500 selling off)
• This is the first time the U.S. enters a possible recession with a Fed that has very few bullets left to work with. Historically U.S. interest rates were in the 6-8% ranges, today we’re in the 1.5%-2.0% range.
• Finally, this is the first recession indication this decade, and should the noise on yield curve inversion impact consumer confidence, there is a non-zero probability that QE may not achieve the desired results.

Risks of a Bearish Positioning

Today, all policy emanating out of the U.S. is intended to insure there is no sell off in the S&P 500. Once markets sold off this month, Trump pulled back on China tariffs, called bank CEOs, and gave Huawei a reprieve. Trump cannot afford a recession in 2020 and will do everything possible to prevent one. The Trump play book will involve a well-timed QE announcement, rate cuts, and some version of a trade deal. Trump has demonstrated a willingness to cave to market pressure and global central banks will once again be desperate to avoid a loss in confidence.

Time and again, it has not paid to be a bear this past decade. Greece, China, Italy were all well packaged crises to justify QE. Therein lies the risk of being too negative.

India’s Biggest Asset is it is a Domestic Oriented Economy But…Stimulus Remains Key

In the event of QE, this liquidity will yet again flood emerging markets, including India. The notion that India’s markets will not be affected is wishful thinking. In the interim, India could be affected by FI flight to quality. Of late, our fundamentals look shaky, and much is dependent on a strong stimulus package.

Large Caps Remain Our Preferred Focus…

Despite calls to the contrary, we’re finding no meaningful bargains in small or mid. The universe of quality opportunities continues to shrink. The market remains quite expensive. The best performing companies are the ones delivering earnings growth. That being the case, we prefer to remain focused on large caps.


The market held 10,800 levels, which form strong technical support. Despite all the hand wringing the market has managed to stabilize at 11,000 levels. A break below the recent support would be a strong signal that the market is headed to test 10,000.


As we’ve listed, there are uncertainties in the macro outlook, and we are in uncharted waters. We recommend strategies such as our Olympians fund, which has not had a losing quarter since 2016 and delivered strong absolute returns. We also recommend Titans, quality multi cap with hedging at potential cycle turns, capital protected strategies, long short, an allocation to Gold and Silver, hedging opportunistically, and an appropriate fixed income exposure will all work to enhance portfolio risk return profiles.

With respect to equities, the market continues to reward companies that can deliver in challenging circumstances. We believe large cap quality growth, and for that matter mid and small cap quality growth, priced reasonably, will deliver. The risks remain on a re-pricing of valuation, or slowdown in earnings, and that’s where we intend to focus attention at a portfolio level.


Gold has a clear breakout and that is a further indication that this time things look different. Gold did have a similar breakout in 2015 that failed, so we wouldn’t get carried away with a Gold allocation, but Gold. clearly deserves an allocation in portfolios, as a hedge against fiat money devaluation. We currently have a moderate overweight in Gold in wealth profiles, offset by a moderate underweight in equities

Gold Is In a Clear Uptrend Breakout

Gold Is In a Clear Uptrend Breakout

Fixed Income

If the global economy is heading into a possible recession, with negative interest rates in parts of the developed world, and the 10-year U.S. treasury at 1.5%, a case for lower yields next year looks possible. Lower crude, low inflation, and slowing demand also suggest that India’s interest rates can continue to head lower. Domestic weakness remains an additional driver to pressure rates lower. Working against a lower rate scenario are India’s plans for rejuvenating growth via a stimulus package, and further clarity should emerge on this in coming days.

The singular reason for owning duration is as a hedge against equity volatility, and one approach to adding duration would be on rate spikes. With these factors driving our reasoning, a diversified portfolio of short, medium term bonds, duration, AAA rated, highest quality, corporate bonds, banking and PSU bond funds remain our preferred positioning.

We’ve avoided credit risk funds for most of the year, and rightly so. Credit risk funds remain risky in the face of worsening global fundamentals. Further, selection risk is another factor to consider as the dispersion of returns is wide, and absolute returns remain sub-par over year to date, and one-year periods.

Technical Outlook

Even though last week had 3-day trading sessions, it was a volatile one. The Nifty finally settled at 11,048 down by 0.56% for week. Nifty is forming higher lows for last couple of weeks, but it is trading in a range with upward bias. Nifty needs to clear 11,200 with momentum for a move towards 11,450 levels. On the downside breaking below 10,900 market is likely to resume its downtrend. The confirmation of downtrend will come once index starts to trade below 10,782 which was the recent low. Below 10,782 index can test 10,450 which is 78.6% retracement of the 10,005 to 12,103 rally. In Nifty options, maximum open interest for Put options is seen at strike price 11,000 followed by 10,700, while for Call option it is seen at 11,000 followed by 11,500. Options open interest distribution suggests range of 10,800 and 11,300 for Nifty. India VIX has been on rise for last three weeks. It closed at 16.65 up by 5.10% on weekly basis. Crossing above 18 levels may lead to lower levels in the market.

Technical Outlook

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