Inverting the yield curve; what’s the prognosis for long term investors?

16 August 2019
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The Noise

  • The inversion of the yield curve; whereby longer term interest rates fall below shorter term interest rates, lead to widespread profit taking in equities as investors looked to bank the strong gains they have made this year in the face of increasing economic uncertainty. 

  • Germany’s economy shrank in the second quarter, with analysts attributing weak auto sales, uncertainty around a disorderly Brexit and the country’s reliance on exporters (particularly to the US and China) as reasons for the contraction. Fears of a potential recession were stoked by similar weakness in economic data from the UK. 

  • Still there was some festive spirit in the air, as Trump decided to delay his China tariffs from September to December, giving companies that are reliant on the Christmas shopping season some room to breathe before next year’s additional taxes start to weigh on profits.

 

The Numbers 

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The Nuance

First and foremost, we position our portfolios to protect against weak economic environments. Our equity allocation – a mainstay of any long term investment strategy – is comprised of companies that are less geared into the economic cycle, and have the pricing power and balance sheet strength to continue to provide goods and services regardless of the machinations of the economy.

But while it’s important to build portfolios that can withstand weakness, it’s equally important to keep a level head and not capitulate to market noise. Investors could have predicted a recession at several points over the last decade – as indeed they have, continuously – and lost out on the kind of market gains that are hard to catch up with once the opportunity has gone. As the old adage goes, time in the market is more important than timing the market. Last December there was widespread fear that we were reaching a recession and the market fell by 20%.  Those who sold out of equities crystallised their losses and missed out on the strong gains rally we have seen this year.

Recessions are hard, and market participants are likely to be particularly sensitive to them given the severity of the last two. In 2001 we had an extraordinary tech bubble to contend with, while in 2008 we faced a broken global banking system. The world economy certainly has some pressures to contend with, but as we see it they are not of the same magnitude as the problems that were building up in the system with these last two.

Furthermore, there is an increased likelihood of a UK recession, but it is not an absolute certainty. Currently, equity markets are expensive but not extremely so, and banks are in far better shape than they were a decade ago. Were we to see a significant market downturn, we would expect to increase our exposure and take advantage of any pull backs to cherry pick the most attractive assets and further improve our long term returns prospects.

Quote of the week

“There were a few case reports — an opera singer and a shouting drill sergeant — but this is far from common” Dr J. Mack Slaughter Jr, ER doctor, Texas
 
When equities hit high notes we all know that the mounting pressure can prove too much, the exuberance overextends and eventually something has to give. It turns out this isn’t a dynamic that’s limited to equity markets. No, singing carries the same health warning, as a man from eastern China found out to his detriment this week; after singing karaoke for so long and with such intensity that he burst a lung. He’s not the only one in recent years either; in 2017 a girl suffered a similar fate due to “prolonged screaming” at a One Direction concert.
 
Source: livescience.com

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