In this edition
What's happening: Markets moved decisively into risk-off mode this week
Why? Investors fear that the rapidly spreading coronavirus will dent economic growth. But since the initial virus cases appeared back in January, why are equities only correcting now? Were investors too complacent?
In the earlier stages of the outbreak, investors expected the impact to be 1) isolated (to China) and 2) transitory. Investors are now rapidly adjusting their expectations given how fast the virus is spreading globally. The market is starting to price a low but increasing probability that the virus will tip the global economy into recession through either an inflationary supply shock (closure of factories, offices, etc) or a deflationary demand shock (lower consumer spending, falling business confidence, etc). The issue is that the long-term damage to growth is almost impossible to estimate. Another concern is that central banks are ill-equipped to deal with such a shock, particularly given how low interest rates are already .
You, as an investor, can react in different ways to the sell-off:
1) If you want (or have to) keep a long-term allocation to equities, you can enter some hedges to protect your portfolio. For example, you can:
2) Profit from second-order effects.
3) You can bet on a rebound.
What is an inverted yield curve?
An inverted yield curve means the yields on short-term bonds are higher than those on long-term bonds. For example, the current yield on a 3-month Treasury bill is 1.47% while a 10-year Treasury bond is only yielding 1.33%.
Is an inverted yield curve normal?
Generally, yield curves are upward sloping. Why? Imagine you lend your friend some money. You would want a higher interest rate if he promises to pay you back in 5 years than if he promises to pay you back next month. Why? 1) It is more risky to lend for 5 years; and 2) inflation could erode the value of your money. If you think about it, banks have built their entire businesses around borrowing money short-term at low interest rates (e.g. from depositors) and lending out that money at higher interest rates over longer time horizons (e.g. mortgages).
“The yield curve is generally upward sloping due to the existence of a risk premium and an inflation premium"
What does it imply?
A yield curve inversion gives us some interesting insights:
Why does it matter?
A 3-month/10-year yield curve inversion has predicted all 9 recessions since 1950 with a 100% success rate. In fact, the Fed dubbed it as the "best summary measure" of an economic downturn, and is typically included in econometric models that try to calculate the probability of recession. It is important to note that, historically, a downturn happened 6 to 24 months after an inversion and not immediately. And there were two occasions where the yield curve inverted but a recession never happened. Markets are good at discounting future outcomes but investors find it hard to time those outcomes. So is it time to go fully defensive in your portfolio?
The chart below shows the difference in yields between 10-year and 3-month bonds (blue line) and the probability of a recession (red line). Source: Econbrowser.com
"You've got no clue what you're talking about you idiot, believe me I'm always right!"
Disagree, but respectfully!
Whether it's at your next assessment centre or at an important team meeting, knowing how to disagree respectfully is a skill often underestimated. Disagreeing is healthy, and is actually something that successful individuals like Ray Dalio are actively seeking (see the link below). However, the way you do it can have a strong impact on your credibility and how you are perceived by your peers. So what should you keep in mind to avoid being perceived as arrogant and close-minded?
Ray Dalio: Seek Out Thoughtful Disagreement
Now, go on and fight!
Take whatever interest rate you are receiving, divide it by 72 and – abracadabra – the result gives you an estimate of how many years you need to double your money! To double it over 10 years, you need a 7.2% interest rate. A more realistic 2%? You need 35 years. Cool, no?!
Have a great week all!
Reda & Stephane