March’s yield curve inversion vs the equity rally
Global equities continue to advance with year-to-date performance now running at 14.4%, supported by the strong growth and cyclical rally
March witnessed fear return with the inversion of the US treasury yield curve. We examine previous episodes and equity performance patterns since 1976
The show goes on
Global equities continued to rally in March. At the time of writing, year-to-date (YTD) global equity market performance stood at 14.4%. The US market continues its strong run this year (+15.7% YTD), supported by the technology sector. The Euro area is up 15.2% YTD, while emerging markets have returned close to 12% in local currency terms (Exhibit 1). Looking at equity styles, growth (+17.1%) and cyclicals (+16.7%) continue to outperform value (+12.4%) and defensives (+10.6%) (Exhibit 2). Around 1.1% of 2019’s total equity returns of 14.4%, come from earnings per share growth, 0.7% from dividend pay-outs and 12.4% from a re-rating in valuation multiples (Exhibit 3).
What happens when the yield curve inverts?
March witnessed a short-lived volatility spike and renewed recessionary fears. The S&P 500 fell 1.9% while the VIX rose 21%, from 13.6 to over 16.5, as a result of investor concerns over the inversion of the US treasury 10-3-year yield curve on 22 March (Exhibit 4). Examining previous yield curve inversion episodes and corresponding equity performance, since 1976, leaves us with little concrete evidence of equity market patterns. Yield curve inversions are generally regarded as a bad omen for risk assets – the return profile of equity markets does deteriorate post yield curve inversions, on average from close to 12% one year before the initial inversion to pretty much flat one year after. Looking beyond averages is advisable, as the range of one year forward returns lies between -25% and 34%, after initial inversions, with a positive/negative return ratio hovering around 50% (Exhibit 5). There also tends to be a meaningful variation in the lags between initial inversions and the eventual market impact, suggesting limited distinction as a market timing tool. Our take is that, an inversion does not point towards a bull or bear market in equities. What it does signal is a fragile economic environment prone to higher volatility, which is in line with our rationale to reduce risk after the sharp rebound earlier this year. The current equity market environment can be largely characterised as sentiment and volatility driven, with prices displaying a high degree of correlation with implied volatility (Exhibit 6).
Negative earnings revisions find a floor
We maintain our neutral stance on global equities in our cross-asset allocation and are sticking to our regional picks of – in order of preference – emerging markets, US equities, followed by the euro area. Turning back to fundamentals, negative earnings revisions appear to have found a floor across the board. Global earnings growth estimates of 4.7% are now looking highly achievable, with prospects of positive surprises in the second half of the year. European shares are starting to appear more attractively priced in our view – especially in the value spectrum, making us more constructive on the space. We prefer to gain exposure through option structures capturing potential upside and capping downside risk.
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