Why I am not changing my portfolio even though the yield curve has inverted

On Friday it was reported that the yield curve in the US inverted for the first time since the last (great) recession. This is supposed to be a reliable harbinger for a future recession in 12-18 months.

What does it mean when the yield curve inverts?

It means the US short-term interest rate (as measured by the 3 month Treasury Bill rate) is now higher than the long-term interest rate (as measured by the 10 year Treasury Bill rate). An inversion like this is generally regarded as a negative market/economic sentiment that can affect economic and market behaviour.

The yield curve inversion has sent some scurrying to make changes to their portfolios by raising cash, selling riskier stocks and becoming more defensive (buying utilities, telcos, REITS and consumer staples equities).

Why I am not scurrying to do anything on the news:

  1. I already have some cash (about 10% of my portfolio, including high-interest savings and short-duration bonds maturing later this year)
  2. I already have good exposure to defensive equities: ~18% utilities + ~11% consumer defensive + ~6.5% communications services + ~3.5% real estate = ~39.0% defensive
  3. I have less than 50% of our total portfolio in equities so a market downturn should be offset somewhat by non-correlated holdings in fixed income, cash and bullion (this was true in 2018, when my portfolio returned ~+1% in spite of equity drawdowns in Canada and the US)
  4. If I sell something to raise cash there could be tax consequences in our non-registered accounts, due to potential capital gains being taxed
  5. I don’t know which non-defensive equities to sell to raise cash – I like all my holdings for the long haul or I wouldn’t own them
  6. Recessions tend to be short and I believe my long-term portfolio is structured well for riding out short-term events
  7. An inverted yield curve has reportedly accurately predicted upcoming recessions eight times (by some sources) since 1968 but, if on January 1, 1968, I bought and held the S&P 500 (^SPX) I would have made a return of 2.81K% in spite of the eight recessions (including the Great Recession of 2008-09)
  8. According to Forbes, the chance of a recession in the next year is always about 27% (based on their data pointing to 16 recessions since 1960) and today the chance is 30%, hardly more than average
  9. If the chance of recession is 30% next year there is also a 70% chance there won’t be a recession next year which means, based on probabilities alone, I should be buying risk-on stocks
  10. If the US Fed surprises by lowering interest rates, that could change the situation immediately
  11. I don’t know how to time when to start re-buying the risk-on equities I am supposed to sell now – presumably when the yield curve corrects to non-inversion

I am not saying a recession won’t happen in 2019-20. It may well.

What I am saying, as a long-term investor who buys, holds and monitors a portfolio of retirement assets designed for all markets, who relies primarily on asset allocation rules when making security weighting decisions, and who makes limited and selective trades intended to improve overall portfolio quality, I don’t react to news like this.

Do you?




What just happened to markets?

Headline stories about the stock market pullback this week were largely focussed on the drop in the Dow Jones Industrial Average (less so on other indexes, but they were not immune). The year-to-date total return marked by the DJIA on January 26 was +7.77%. By the close on Friday, the DJIA had settled to +3.34% YTD, a drop of around 4%.

This is a relatively large drop given the low volatility and upward trending we’ve seen in markets in the last couple of years. By historical standards this is a mere blip, and 3.34% YTD total return still represents, annualized, over 35% growth!

I was in my car last night and caught a story on the news radio about the stock market pullback. The commentator didn’t really have a very clear rationale for drop – something about markets and the broad economy not being correlated….. The broad US economy is doing well, creating jobs and growing, but markets took a big pause.  Hmmm. I didn’t find that very satisfying.

A few minutes earlier I had read in WaPo the main reason that markets pulled back, and especially on Friday, was to do with the 10 year benchmark interest rate surpassing 2.8%, on its way perhaps to 3%. The case was made that a 3% benchmark rate will send a signal to some investors that bonds might be more attractive than stocks on a risk-adjusted basis.

I read another article this morning in the NY Times that makes a similar point and goes on to say there may actually be a connection between the pullback and the broad economy: expectations are that the broad US economy is going to grow at, say, 1.5% not the 3% promised by Donald Trump.

So maybe there is a decent connection between stock market indexes and the broader economy after all. Given how expectations affect spending and investment decisions so heavily – both in markets and in the economy at large – this really shouldn’t be a surprise. And the 10-year interest rate moves in large part due to expectations about inflation rates and the cost of money in the future. Inflation expectations may be climbing.

This tells me, perhaps, that expectations could well be shifting to lower future growth rates in the economy and to lower investment returns from markets. Nothing says these expectations will be proven correct, but it is worth noting.

It is also worth reminding that last year’s market performance is no guarantee of future performance. But even at a 3.34% total return YTD, the DOW isn’t exactly off to a bad start.

Wow, that was a relief!

Times have changed. The US Fed raised rates today and what did the stock market do? It went up of course!

Remember back in the dark days of December 2015 to February 2016, the period after the Fed first raised rates since the financial crisis? The market had a tantrum, didn’t it?

I guess today’s relief was the Fed chose to increase by only 0.25% rather than the 0.5% some were anticipating.

I love how many people say these rate increases are all “baked in” to the market before they happen. If that were truly the case, there would be no reaction at all once the rates change. Unless it’s selling on the news which today was clearly not the case as buyers were out in force.

As a side note, today was my self-imposed trading date (coincidentally) and I tried to be super clever and made my sells in the morning and my buys in the afternoon, hoping for a bit of a pullback. Well, that didn’t work out as I should have been buying in the morning and selling in the afternoon.

Goes to show how hard it is to predict the markets. Good thing I am a long-term investor and a small change in one day isn’t going to make much difference to us.

The US Fed has held fast on rates

As most people know the US Fed decided to not raise interest rates at its first policy meeting in 2017.

The Federal Open Market Committee statement described things thusly:

“…the labor market has continued to strengthen and that economic activity has continued to expand at a moderate pace. Job gains remained solid and the unemployment rate stayed near its recent low. Household spending has continued to rise moderately while business fixed investment has remained soft. Measures of consumer and business sentiment have improved of late. Inflation increased in recent quarters but is still below the Committee’s 2 percent longer-run objective. Market-based measures of inflation compensation remain low; most survey-based measures of longer-term inflation expectations are little changed, on balance.”

Its forward-looking statements included:

“The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run.”

So, it’s wait and see. Hardly a ringing endorsement but neither is it a negative outlook.

See the full press release here.

Yellen did it again

For the second time in a year (almost to the day) Janet Yellen raised interest rates by 1/4 point in the US. This is just the second time in about 10 years that rates have gone up.

The market pulled back a bit even though the rate increase was widely expected, and reportedly “priced in.” Apparently that was because the Fed set an expectation that rates will go up again more than once in 2017.

Slow, steady increases in rates in a growing economy should not derail markets. If profitability rises, so will fundamentals, and hence share prices should follow accordingly. It would make sense for rates to climb too under those conditions.

Today could well have been another example of selling on the news.

Why doesn’t the Fed move rates in smaller increments?

I was involved in an email exchange today with some Share Club members about the topic of the expected 1/4 percent increase in the US interest rate. Minutes from the last Fed policy meeting held April 26-27 were released today.

Last December the Fed decided rates should go up:

The Fed raised its benchmark federal-funds rate in December to a range between 0.25% and 0.50%, after leaving it near zero for seven years. At the time, officials projected they would raise rates by a full percentage point this year. But officials cut that estimate in half at their March meeting, as worries about risks from abroad and turbulent financial markets had stayed the Fed’s hands on interest-rate increases in the early months of the year. Wall Street Journal

Given the market hiccups that followed the December increase this January and February, and again today’s reaction to the possibility of the next increase, I have to wonder why the Fed doesn’t move in smaller increments.

Rates in December, before the increase, were near zero, and then they went to between 0.25 and 0.5 percent. Proportionately, that is a huge increase.

Wouldn’t it be better, given the near-zero starting point, to raise rates in smaller increments? What’s wrong with 0.10 percent for each raise? There could be more increases over the course of time, but each one would have a much smaller relative impact, allowing markets to absorb the increases more gradually.

Unprecedented times of near-zero rates just might demand an unprecedented path to returning to something more normal.

Where is it cast in stone rate increases have to be in 0.25 percent or more increments?