Should we panic over treasury yield curve inversion?
Investors worked themselves into a tizzy in early-December last year, sending stock prices tumbling around the world. That was when the Treasury yield spread fell sharply (see Chart 1), to the lowest levels since the global financial crisis.
Chart 1: Precipitous drop in Treasury yield spread
For those unfamiliar with Treasury yield spread – it is the difference between the short- and long-term bonds. The US Federal Reserve sets short-term interest rate while investors determine rates/yields on the long-dated bonds via market prices.
Yields on the long-dated treasury are typically higher than that for shorter duration ones, due to the additional term premium – to compensate for inflation over the duration.
Hence, when the difference in yields between the 2- and 10-year bonds – the most popular market yardstick for Treasury yield spread – dropped to just 0.11% in late-2018, investor worries spiked. When this gap turns negative, we deem the yield curve as inverted.
The event made for sensational news headlines, triggering fear in markets around the world. Why is a potential yield inversion taken as such an ominous sign for stocks? Well, for one thing, the last five recessions in the US were preceded by an inversion of the yield curve.
In reality, the steepness of the yield curve offers little in terms of fresh insight into the underlying economy and more of changing investor expectations.
In December, investors’ views took a pessimistic turn on the US and global economy and their actions – buying up long-dated bonds caused yields to fall (bond prices and yields are inversely correlated).
Falling long-dated yields while short-term yield remained high translate into flattening of the yield curve. In extreme cases, the yield curve will invert. When that happens, it means investors expect a recession.
If the yield curve inversion and recession happen at the same time, which causes which? Bond yields – like stock prices – are reflective of investor expectations for the future. But as we well know, expectations are as likely to happen as not.
That said, inversion of the yield curve may have psychological effects that could be self-fulfilling, if it causes everyone to believe that recession is imminent. Banks could start to tighten lending requirements – because of greater risks and lower profitability (smaller net interest margins) – thereby stifling credit, businesses would delay investments and hiring and consumers could start to spend less, all of which will result in slower economic growth.
Is the yield curve inversion a signal to sell stocks?
Even if yield curve inversion does precede recession, it can neither predict the timing, length nor depth of the recession – and crucially, how stock markets react. Historically, inversions have happened between 6 months to two years before recession – during which stocks have traded flattish, up and down. (See Chart 2)
Chart 2: Is there a correlation between yield spread and stock markets?
I think all these just mean that trying to predict stock market movements is a fool’s errand. Narratives, it seems, do not move stock prices. Rather, reasons are provided for stock movements, after the fact.
As value investors, we would be much better off looking at the underlying business, earnings, cash flows and balance sheets instead of trying to time the market.
Is a recession imminent?
Economic cycles of expansions and recessions are as inevitable as death and taxes. But I do not think there is any fundamental reason for economic expansion to die from old age.
In theory, economic growth gets derailed when rising demand for goods, capital and labour causes inflation, which then results in governments (over)-tightening monetary policy that will lead to a slowdown or worse, recession.
However, this traditional relationship between output, employment and inflation appears to have broken down. Case in point, the US recovery is heading into its tenth year and unemployment is at 50-year lows, yet inflation remains benign, barely above the Fed’s 2% target.
Real interest rates remain low by historical standards. This is due, in big part, to technology advancements and digitalisation, which have been very effective in capping inflationary pressures.
We have seen how technology and digitalisation greatly enhance operational efficiency, improve the price discovery process, raise assets utilisation and productivity and so on.
Technology underpinned the rise of the oil shale industry and brought oil prices down from record levels. Continued advancements in green energy technology will likely keep future prices lower. Low oil prices, in turn, play a huge role in tempering costs and price inflation.
The Treasury yield spread has widened a little since the lows in December, currently hovering around 0.18% – as the worst of investor panic subsided. It may or may not fall into negative territory in the coming weeks or months, as investors continually recalibrate their expectations for the future.
Regardless, I suspect the yield curve will be flatter than we are used to seeing in the past, even after the Fed normalises monetary policy, due to low inflationary expectations.
Plus, in reality, most recessions are triggered by exogenous events – such as geopolitics, war, trade conflicts and asset bubbles – that are inherently unpredictable.
Stocks in my Global Portfolio ended mostly higher for the week. Total portfolio value gained 5.2%. China-based companies including Sunpower, Nine Dragons and Ausnutria Diary performed well after the long Chinese New Year break.
Investor sentiment for equities stayed positive amid rising expectations of a US-China trade deal while a more dovish US Federal Reserve is aiding the recovery in emerging market currencies.
Last week’s gains pared total portfolio losses to just 4.1% since inception. By comparison, the MSCI World Net Return Index is down by a lesser 0.4% over the same period.
The FBM KLCI, however, fared comparatively poorly, continuing to underperform regional markets. The bellwether index is down 0.3% for the week ended Thursday and remains in negative territory for the year-to-date.
Positively, stocks in my Malaysian Portfolio fared better than the benchmark index, with total portfolio value gaining 1.7%. Notably, shares for Formosa Prosonic – one of InsiderAsia’s top 10 stocks for 2019, were up 11%. For more InsiderAsia stock picks, check out www.absolutelystocks.com.
Total portfolio returns now stand at 53.1% since inception. This portfolio continues to outperform the benchmark index, FBM KLCI, which is still down 7.7%, by a long way.
Performance Comparison Since Inception (%)
- Tong's Value Investing Portfolio
- FBM KLCI
|SHARES HELD||QUANTITY||AVERAGE COST||COST OF
|AJINOMOTO (M) BHD||11.813||17,720.0||18.740||28,110.0||10,390.0||58.6%|
|PANASONIC MANUFACTURING MSIA||26.157||17,182.0||38.100||22,860.0||5,678.0||33.0%|
|Y.S.P.SOUTHEAST ASIA HOLDING||2.413||25,340.0||2.750||28,875.0||3,535.0||14.0%|
|FORMOSA PROSONIC INDUSTRIES||1.540||27,720.0||2.020||36,360.0||8,640.0||31.2%|
|HONG LEONG INDUSTRIES BHD||9.126||18,251.0||9.360||18,720.0||469.0||2.6%|
|MALAYAN BANKING BHD||10.250||30,750.0||9.550||28,650.0||(2,100.0)||(6.8%)|
|ECO WORLD DEVELOPMENT GROUP BERHAD||1.235||18,772.0||0.915||13,908.0||(4,864.0)||(25.9%)|
|DIALOG GROUP BHD||3.452||19,676.4||2.990||17,043.0||(2,633.4)||(13.4%)|
|SAM ENGINEERING & EQUIPMENT||7.380||22,140.0||7.540||22,620.0||480.0||2.2%|
|POH HUAT RESOURCES HOLDINGS||1.490||19,370.0||1.550||20,150.0||780.0||4.0%|
|SUPERLON HOLDINGS BHD||1.300||19,500.0||1.300||19,500.0||0.0||0.0%|
|Total shares held||255,639.8||270,517.8||14,878.1||5.8%|
|WILLOWGLEN MSC BHD||0.497||9,900.0||0.464||9,236.0||(664.0)||(6.7%)|
|Realised Profits / (Losses)||91,330.0|
|Change since last update Feb 7, 2019|
|Portfolio Returns Since Inception||200,000.00||306,208.1||106,208.1||53.1%|
|Portfolio Returns (Annualised)||12.2%|
|Risk Adjusted Returns Since Inception||79.1%|
|Performance Comparison||At Portfolio Start||Current||Change||Relative Portfolio Outperformance|
*Current price is as at February 14, 2019.
*Portfolio started on Oct 10, 2014 with MYR200,000.
*This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks.
|SHARES SOLD||DATE BOUGHT||DATE SOLD||QUANTITY||AVERAGE
|PANASONIC MANUFACTURING MSIA||21-Jan-16||27-Jul-17||400||26.125||10,450.0||37.100||14,840.0||4,390.0||42.0%|
|ELSOFT RESEARCH BHD||30-Mar-17||24-Aug-17||8,000||1.844||14,750.0||2.650||21,200.0||6,450.0||43.7%|
|JOHORE TIN BERHAD - WA 12/17||04-May-17||24-Aug-17||17,000||0.655||11,135.0||0.680||11,560.0||425.0||3.8%|
|FOCUS LUMBER BERHAD||03-May-17||30-Aug-17||6,000||1.660||9,960.0||1.530||9,180.0||(780.0)||(7.8%)|
|WILLOWGLEN MSC BHD||23-Nov-16||30-Aug-17||7,000||0.768||5,377.0||1.430||10,010.0||4,633.0||86.2%|
|WILLOWGLEN MSC BHD||23-Nov-16||28-Sep-17||7,000||0.770||5,377.0||1.180||8,260.0||2,883.0||53.6%|
|LII HEN INDUSTRIES BHD||14-Dec-16||28-Sep-17||5,000||2.820||14,100.0||3.720||18,600.0||4,500.0||31.9%|
|COMFORT GLOVES BERHAD||28-Aug-17||08-Dec-17||25,000||0.960||24,000.0||0.930||23,250.0||(750.0)||(3.1%)|
|JOHORE TIN BHD||08-May-17||08-Dec-17||9,000||1.600||14,400.0||1.180||10,620.0||(3,780.0)||(26.3%)|
|THONG GUAN INDUSTRIES BHD||12-Dec-16||08-Dec-17||5,000||4.243||21,215.0||4.100||20,500.0||(715.0)||(3.4%)|
|KERJAYA PROSPEK GROUP BERHAD||12-Jan-17||15-Mar-18||11,000||1.025||11,280.0||1.540||16,940.0||5,660.0||50.2%|
|KERJAYA PROSPEK GROUP BERHAD - WARRANTS B 2018/2023||08-Mar-18||15-Mar-18||3,000||0.000||0.0||0.330||990.0||990.0||-|
|LUXCHEM CORPORATION BHD||30-Aug-17||15-Mar-18||16,500||0.732||12,072.5||0.720||11,880.0||(192.5)||(1.6%)|
|WILLOWGLEN MSC BHD||14-Dec-17||22-Mar-18||20,000||1.010||20,200.0||1.260||25,200.0||5,000.0||24.8%|
|MUAR BAN LEE GROUP BERHAD||26-Oct-17||22-Mar-18||13,500||1.240||16,740.0||1.170||15,795.0||(945.0)||(5.6%)|
|CHOO BEE METAL INDUSTRIES BHD||07-Sep-17||16-May-18||8,000||2.190||17,520.0||2.440||19,520.0||2,000.0||11.4%|
|CHOO BEE METAL INDUSTRIES BHD||07-Sep-17||21-May-18||8,000||2.190||17,520.0||2.300||18,400.0||880.0||5.0%|
|SUPERLON HOLDINGS BHD||01-Dec-17||21-May-18||6,000||1.175||7,050.0||1.550||9,300.0||2,250.0||31.9%|
|OKA CORPORATION BHD||14-Dec-17||28-Jun-18||12,000||1.541||18,488.0||1.270||15,240.0||(3,248.0)||(17.6%)|
|SUPERLON HOLDINGS BHD||01-Dec-17||28-Jun-18||6,000||1.175||7,050.0||1.210||7,260.0||210.0||3.0%|
|WILLOWGLEN MSC BHD||14-Dec-17||28-Jun-18||100||0.500||50.0||0.540||54.0||4.0||8.0%|
|PANTECH GROUP HOLDINGS BHD||17-May-18||02-Aug-18||43,000||0.580||24,940.0||0.560||24,080.0||(860.0)||(3.4%)|
|KERJAYA PROSPEK GROUP BERHAD||10-Jan-17||06-Sep-18||11,000||1.020||11,225.0||1.400||15,400.0||4,175.0||37.2%|
|LUXCHEM CORPORATION BHD||25-Aug-17||06-Sep-18||16,500||0.717||11,825.0||0.655||10,807.5||(1,017.5)||(8.6%)|
|HOCK SENG LEE BHD||19-Apr-18||06-Sep-18||14,500||1.520||22,033.0||1.370||19,865.0||(2,168.0)||(9.8%)|
|GENTING MALAYSIA BERHAD||06-Sep-18||28-Nov-18||3,800||5.070||19,266.0||3.060||11,628.0||(7,638.0)||(39.6%)|
|TOP GLOVE CORPORATION BHD||06-Sep-18||06-Dec-18||3,600||5.500||19,800.0||6.030||21,708.0||1,908.0||9.6%|
|MAH SING GROUP BHD||28-Jun-18||14-Jan-19||19,000||1.005||19,095.0||0.930||17,670.0||(1,425.0)||(7.5%)|
|WILLOWGLEN MSC BHD||14-Dec-17||14-Feb-19||19,900||0.500||9,950.0||0.464||9,236.0||(714.0)||(7.2%)|
A Note to Readers
It is my pleasure to share with you my Value Investing Portfolio. However, I must emphasize that it is by no means a recommendation or a solicitation or expression of views to influence you to buy or sell any stocks. I am just sharing openly on what I am doing with my stock portfolio.
Further, I like to remind all investors that investing is not just about the profits or returns. You will inevitably suffer stock losses too. You need to understand your own investment objective, risk appetite and the amount of loss you can afford to bear. So, while many investors talk only about absolute returns, I am also sharing the computed risk-weighted returns of my portfolio.
Tong Kooi Ong