Warnings from the inverted yield curve

Tougher times ahead for stocks?

In his previous article on the current steep yield curve inversion, Stephen Dover, Head of the Franklin Templeton Institute, looked at how this inversion compares with previous episodes and how stocks and bond react differently. With this article, Stephen focuses on equities and implications for investors.

Why are equities are prone to fall when the yield curve normalizes? After all, interest rates (and hence discount rates) are typically falling as the yield curve normalizes, which should be bullish for stocks.

The answer resides in my previous discussion about the predictive power of the yield curve for recessions and, by extension, for profits. As noted, in preceding cycles dating back to 1970, an inverted yield curve always pre-dated a recession. During those downturns, as the economy weakened and inflation pressures abated, the Fed eventually relented and cut interest rates. But by then it was typically too late to engineer a “soft landing,” where inflation fell but the economy continued to grow.

When corporate profits shrink

For equities, the real killer is what then happened to corporate profits. Without exception, when the economy fell into recession, economy-wide corporate profits also fell (Exhibit 1). Importantly, as demand weakened, firms lost pricing power, meaning that revenues shrank even faster, especially relative to costs. The outcome was typically a nasty profits recession.

That debacle is evident in Exhibit 1, which shows U.S. corporate profits as a percentage of U.S. gross domestic product (GDP) – a measure of profits to total sales in the economy and a good approximation of aggregate profit margins. In each recession (as indicated by the grey bars), except 1990, profits growth turned negative, exacerbated by a fall in profits relative to sales (i.e., relative to GDP).

So far in 2023, that is not happening. Indeed, quite the opposite is occurring. This year, despite falling S&P 500 profits at a -5% year-on-year rate for the fourth quarter 2022, equity markets have jumped higher, boosted by expectations of a pause in the Fed’s hiking cycle and hopes that a Fed “pivot” to lower rates will quickly follow.¹

To an extent, this year’s rally makes sense. After all, the sooner the Fed pauses, the less damage it will do to the economy and profitability. So equity investors are right to cheer a slowing in the rate-hiking cycle. And they are also pleased by signs that the economy is not yet buckling, as shown by solid U.S .jobs growth and a remarkable drop in the unemployment rate to a 54-year low of 3.4%.

But equity investors should be wary of becoming overly exuberant. As Fed Chairman Jerome Powell and his Federal Open Market Committee (FOMC) colleagues have repeatedly pointed out, inflation remains too high and, in their view, is unlikely to recede to its target level without some job losses.² The abnormalities in today’s labor market (e.g., lower labor force participation rates) therefore, are keeping the Fed tighter for longer, which only increases recession risk later this year. In short, good news about the economy, which investors are ready to celebrate, could portend even harder times ahead.

Implications for investors

History strongly suggests that at this juncture in the monetary policy and economic cycles, yield curves are nearing a point of normalization. Yield curve inversion is not a lasting feature of the capital markets landscape.

History also suggests that during yield curve normalization, bonds outperform stocks in absolute as well as risk-adjusted terms. That’s our view for the next few quarters as well.

A key reason is the risks that lie ahead for corporate profits, which are already falling. They are likely to remain weak for much of 2023. The powerful start for equities in the first six weeks of 2023 has pulled forward into valuations whatever meager good news profits can offer this year, leaving valuations exposed to weaker economic conditions.

Yield curve normalization will only take place once the economy softens. That might take longer than usual, given a very tight labor market. But the risk for investors is a Fed that is “higher for longer,” with pain merely postponed. Still, equity markets might prefer a delayed normalization of the yield curve. After all, when it arrives, it is rarely good for them.

For once, therefore, equity investors might be inclined to think that when it comes to yield curves, abnormal is worth relishing. Enjoy it while it lasts.

Notes

1. Source: FactSet, as of February 10, 2023.
2. Source: US Federal Reserve.

Stephen Dover, CFA, is Franklin Templeton’s Chief Market Strategist and Head of the Franklin Templeton Investment Institute. Originally published in Stephen Dover’s LinkedIn Newsletter Global Market Perspectives. Follow Stephen Dover on LinkedIn where he posts his thoughts and comments as well as his Global Market Perspectives newsletter.

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