In March, I was listening to a podcast with James Aitken, the founder of Aitken Advisors, a one-man macroeconomic consultancy based in Wimbledon, England. The firm works with some of the most influential pools of capital in the world. The ‘macro’ outlook matters to many of these investors when trying to predict the big picture. This is no small undertaking as it requires constant testing of one’s outlook and sometimes patience, in waiting for an outlook to play out. There are many successful macro investors, some of whom are more short-term trading-oriented, trading around a big picture view. A crucial tenant of macro investors is they must protect on the downside and be quick cut their losses. This is in case either their forecast is wrong, or it changes both of which occur often.
Aitken discussed the importance of the psychology of investing. Among the many challenges of investing is when an investor is faced with a loss, due to the facts changing, and then must decide how to deal with the opportunity loss from making the wrong decision. He called this ‘maximum regret’.
An example would be investors who were expecting European bank stocks to do well this year based on fundamentals and then have a geopolitical event such as Russian/Ukraine sideswipe those investors. They are then faced with a dilemma - sell stocks down 20-25%, or do they ride it out? It’s a tough short-term vs long-term decision, in trying to position a portfolio.
I bring this up because the first quarter of 2022 had several worrying events for investors, each of which could have led to ‘maximum regret’ as the year started on a negative note. There were inflation concerns, which were exacerbated by each economic data point that was released. There were concerns about the US Federal Reserve and Bank of Canada raising interest rates, while also being behind the curve, and too slow to start said rate hikes, which led to worries that central banks were going to have to be more aggressive in raising rates than the markets had initially thought. Additionally, the fears of a war in Eastern Europe unfortunately became reality, which has caused supply shortages in many commodities, adding to inflation concerns.
In life, we worry about events and often the worrying is worse than the actual event. Stock markets are very similar. Investors are emotional and can often worry about events that may or may not occur. But often when the event happens, it does not play out as expected. Of course, it is impossible to anticipate every market impacting event. There will be many, with some more impactful than others, throughout our investment lifetimes. More importantly, the market is a discounting mechanism that prices in these events, often as far as 6-9 months in advance (if not longer)!
This comes back to those macro investors who are trying to predict what will happen and then positioning themselves accordingly. We hear and read many market forecasts and the negative outlooks tend to get more headlines. In 2020, we had a pandemic, which was an unexpected event, but we also had a strong market recovery – that few predicted in that year. There will always be unexpected events, both positive and negative, but we tend to remember the negative ones more.
Yield Curve Inversion
What does ‘yield curve inversion’ mean and why does it matter to investors?
Normally, longer-duration interest rates are higher than short-duration rates to account for the extra risks of time. For example, a 20-year bond should offer a higher yield than a bond with five years until maturity. The yield curve is a plot of these yields for different durations of the same instrument and normally the curve slopes upward as term to maturity increases. On the infrequent occasions, when the yields on longer durations are lower than those of short durations, the curve slopes downward and is said to be negative or "inverted". This inversion recently occurred when last week 2-year US Treasury yields were slightly higher than 10-year bonds.
In general, a simple way to look at the importance of the yield curve is to think about what it means for a bank. The yield curve measures the spread between a bank’s cost of money versus what it will make by lending it out or investing it over a longer period. If short term rates are higher than long term rates, banks can be challenged to generate profits because lending slows, and slower economic growth sometimes follows.
If the curve inverts, many think we are in a recession or close to a recession. However, we saw a strong labour report last Friday with the US unemployment rate dropping to 3.6%. We are all seeing a strong jobs market in Canada. This means conditions are getting incrementally better, not worse. As a result of inflationary pressures and a stronger economy, the Federal Reserve and the Bank of Canada want to tighten financial conditions (i.e. increase interest rates). Rates have been very low for an extended time, part of that was for emergency reasons such as the brief recession that ensued following the onset of the pandemic. Those times have passed, meaning Central banks need to raise rates because of a healthier economy and to combat inflation.
It is important to note that in the last four occurrences where the 2-year/10-year yield curve inverted, the S&P was up an average of 28.8% before a peak was reached. The ultimate peak was 17 months later with a recession starting 21 months later. So, it is a ‘warning’ but not so straightforward as a timing indicator. If an investor was told the market would be up 28.8% before an event happened, most would think that sounds pretty bullish. Also, some investors believe the 3-month yield to the 10-year yield is the more accurate recession forecaster, and that curve has not flattened at all. The spread for that curve has been widening, a potential signal for stronger economic growth in the months/quarters ahead.
There will always be market indicators that could give an investor pause and attract a lot of attention. Some may come to fruition, while others will be false alarms. This is why it is important for investors to think in terms of months and years, not in days or weeks, when it comes to their investment portfolios. We have little way of knowing what markets will bring over the short term. There will always be negative events resulting in tougher periods for the markets. However, we do know, that over the medium term and certainly long term, the magic of compound returns will reward the patient investors who stick with their investment plan.
Favorite Recent Reads
- Corporate Bond Markets are Shrugging Off the Global Worries - FT (Paywall)
- Given everything that is worrying investors right now — from the Russia’s invasion of Ukraine, to rampant inflation and a hawkish Federal Reserve pulling the punch bowl away from investors by tightening monetary policy — they should be keeping a close eye on the high-yield bond market. But in recent periods of stress, such as earlier this year, it hasn’t budged. Instead, the stock market has been most responsive. Why is that the case? It’s arguably because the stock market volatility this year has not been about fundamental weakness in the economy, but rather about resetting of expectations over the Fed raising interest rates. If this is correct, credit has been flashing the right signal that all is still fundamentally fine.
- Carmakers Dream of Clean, Green, Mean Electric Machines - Reuters
- An interesting read on the challenges and opportunities that car manufacturers are facing to develop a truly green vehicle.
- Brookfield Billionaire Flatt Reveals Secret Behind 3,700% Return - BNN Bloomberg
- His beginnings in Winnipeg, why he books on OpenTable and finds taking the subway to be “the most efficient way to get around”.
- The Predictive Power of the Yield Curve - Wealth of Common Sense
- A historical analysis on what an inverted yield curve might mean for markets.