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Mid-Year Update – Getting the yield curve wrong

Daniel Morris
By DANIEL MORRIS 26.07.2023

In this article:

    Many investors have been puzzled for most of this year by an inverted US yield curve, which along with economist forecasts and CEO surveys signals an impending recession. At the same time, the performance of risk assets suggests a much brighter outlook. Which is right and which is wrong?

    Despite negative investor sentiment, equities have outperformed government bonds so far this year (see Exhibit 1), as has corporate credit (notably high-yield). Consensus forecasts have consistently projected rising earnings instead of the declines one typically sees in a recession.

    One possible explanation for the apparent divergence in views between the markets could be simply that one market is right and the other wrong and that eventually they will converge. Assumedly,  equities will fall once the market ‘realises’ a recession is actually in store (as we believe). While convergence is possible, it seems unlikely to us that markets could sustain such a schizophrenic view for so long.

    How to reconcile the opposing stances?

    There is an alternative explanation: interpreting the inverted yield curve as a recession signal is incorrect. While it is true that historically an inverted curve has often been followed by a recession, it is not inevitable that recession will follow.

    The inverted curve simply reflects 

    • High interest rates today as central banks aim to slow economic growth and hence inflation
    • Lower rates in the future once growth and inflation decline. 

    That is, the inverted curve (accurately) forecasts a slowdown in growth, but that slowdown does not have to end in recession. This is not to say current bond market pricing excludes the chance of a recession, just that the markets reflect a scenario where the probability of a slowdown is greater than the probability of a recession.

    There are two reasons why things may be ‘different this time’, with the inverted yield curve not being followed by a recession.

    The Fed is aiming to steer the economy to a soft landing, so it may err more on the side of letting inflation stay higher for longer rather than raising rates even more aggressively to get inflation back to its 2% target quickly. It is worth noting that the June monetary policy meeting, the Fed not only held rates steady, but it also raised its inflation projection for 2023.

    The other key difference is that the US economy is in a different state than during previous slowdowns. Thanks to fiscal stimulus, consumer demand has remained strong. The first-quarter drawdown in inventories actually reflected that strength in consumption.

    If GDP growth is expected to slow merely to a below-trend rate, it is perfectly reasonable that equities should rise and that earnings are forecast to grow in the year ahead. Even with a recession, the economy is still expected to grow by 3% in nominal terms in 2024.

    US consensus earnings forecasts have already been revised down and call for flat earnings growth (ex-energy) this quarter. For the rest of the year and into 2024, however, expectations are much higher: 6% for the third quarter, 13% for the fourth, and a similar rate for 2024 (see Exhibit 2).

    In our view, these forecasts are likely still too optimistic.

    Europe – Back to normal

    The outperformance of European equities over US equities since the start of the Ukraine war is unlikely to be repeated over the next year. We also expect a slowdown in Europe and consumers are in a far less strong position to drive growth. US businesses benefit from the Inflation Reduction Act.

    It is worth recalling, however, that before the war, most investors were quite optimistic about the outlook for Europe. 2022 was going to be the year when the economy reopened fully after the pandemic and corporate profits were expected to surge.

    Despite the shock from the war, that surge did largely occur. Earnings in 2022 rose by 14% in Europe versus just 4.7% in the US. Now, however, earnings trends are likely to revert to normal, with superior profit gains expected in the US.

    China – Will valuations recover?

    Chinese equities have disappointed many investors. The initial run-up in the market after the end of the zero-Covid policies was expected to continue, following the pattern of US and European equities when those regions reopened.

    The disappointment, however, is somewhat unwarranted as high expectations did not take into the account the differences in support provided by governments to households during lockdowns.  

    There is more to the underwhelming performance, however, than just cyclical growth worries. It appears there has been a broader reassessment of the prospects for Chinese equity returns. This is partly a function of the increasing decoupling of China and the US (and to some degree Europe). Though the domestic Chinese economy is certainly large enough to generate significant future profit growth for domestic companies, investors worry about their ability to capture it.

    One major challenge that remains – with no easy solutions available – is to reduce indebtedness in the property market without unduly slowing growth.

    As a result of this reassessment, relative valuations of Chinese equities have dropped to Global Financial Crisis (GFC) lows  (see Exhibit 3). However, multiples may not revert to their historical average. Investors seem less inclined to assume China risk now with growth slowing, particularly as Chinese equities did not outperform global equities even when China’s growth rates were far higher.

    Despite this, we expect Chinese equities to recover in the months ahead with Beijing likely to provide more stimulus to boost growth, possibly in the form of policy rate cuts, forceful measures to underpin the property sector and fiscal support.

    We believe that at least some of the higher earnings growth rates expected for Chinese equities will be realised. At a minimum, growth rates will exceed those in the US or Europe. Consumer discretionary, financials and technology should see rising earnings after three years of lockdowns.

    We believe investor pessimism has deepened too far and that the market will eventually reward growth in corporate profits.

    The outlook for rates

    The key question for the outlook of US policy rates is whether core inflation can decelerate without a meaningful rise in unemployment from a recession. Inflation data over the last two months suggests that it indeed may be possible.

    The latest data showed the bulk of inflation stemming from shelter costs (see Exhibit 4). Encouragingly, core services inflation, which is assumed to be sensitive to wage gains, is slowing faster than the rate of wage growth. This data may help explain why the current one-year forward market forecast for inflation is just 2.3%.

    If a recession does begin to materialise, US Treasury yields would likely plunge, perhaps to as low as 3%, and the market forecast of just one cut in the fed funds rate by the first quarter of 2024 may be pessimistic.

    Alternatively, if inflation and growth continue to moderate, the Fed may be able to cut policy rates faster as it will have achieved its desired soft landing.

    Whatever the case, we believe the environment for Treasuries remains positive as investors should at least earn the current coupon, with potential price appreciation under numerous scenarios.


    Please note that articles may contain technical language. For this reason, they may not be suitable for readers without professional investment experience. Any views expressed here are those of the author as of the date of publication, are based on available information, and are subject to change without notice. Individual portfolio management teams may hold different views and may take different investment decisions for different clients. This document does not constitute investment advice. The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay. Past performance is no guarantee for future returns. Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher-than-average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity or due to greater sensitivity to changes in market conditions (social, political and economic conditions). Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.

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