Looking at this week’s chart, we can see the U.S. is one of the best performers in global markets. In an environment where the global liquidity provided by central banks is shrinking, this performance is even more impressive.
Besides the technical factor that U.S. equities have a much larger weight in the technology sector, three macro factors drove the outperformance of U.S. equities: fiscal stimulus, record share buybacks and volatilities in emerging markets.
Deregulation and tax cuts rekindled animal spirits in the U.S., with strong earnings and U.S. dollar repatriation flows driving share buybacks to record highs. These two factors are positive for equity returns; however, the tightening of monetary policy is now being felt by emerging markets. As in 1998, financial stresses overseas are driving up the demand for safe-haven dollar assets, thus benefiting U.S. equity performance.
At the end of this year, the European Central Bank (ECB) will end its bond purchase program, and is expected to begin raising rates next September. As a result, Euro funding will also start to tighten next year. Given current U.S. equity market valuations, trade conflict between the U.S. and China and the trajectory of monetary policy, I think it may be prudent to hedge equity market risk.
There is one risk to this thinking, however. Even though I believe we are late in the cycle, it can be extended by additional fiscal stimulus. I believe last year’s Tax Reform and Jobs Act extended the cycle by at least 18 months. If Democrats take the House, as the market expects, a new infrastructure deal could extend the cycle another 12-18 months.
As opposed to hedging equities, I prefer yield curve steepeners. The 2- and 10- year Treasury yield spreads have been grinding narrower and narrower in the last five years. Now it stands at 25 basis points (bps), an attractive entry point for curve steepeners.
An investor may benefit from holding this position. The trade has positive carry and roll down returns should the curve remain stable. More importantly, a curve steepener protects the portfolio from the risk of an overheating or sudden slowdown of the economy.
If the economy overheats, the long-term inflation expectation will usually rise and the front end of the curve will be anchored by Federal Reserve (Fed) decisions. Usually, we will see the 10-year rate rise higher than the 2-year rate, which is a bear steepener. If we have an economic slowdown, both the 2-year rate and 10-year rate will usually come down. The 2-year rate will come down more, however, because the Fed rate cuts affect the short end more than the long end, thus leading to a bull steepener.
If the economy continues to strengthen and the Fed keeps hiking rates to prevent the overheating, this poses a risk to the trade. If the market perceives that the Fed is ahead of the curve and risks driving the economy into recession, then the curve tends to flatten or simply remain flat. This will cause some short-term headwind for the position. This eventually will be resolved, however, either by higher economic growth/inflation or recession, both leading to a steeper yield curve. With a positive carry profile, it is not too difficult to hold the position through this period and wait for the eventual steepening.
Key Takeaways
U.S. equities have outperformed the rest of the world significantly this year, and the yield curve is very flat. A curve steepener may serve as good protection for risk of recession or an overheating economy. Monetary stimulus tends to exacerbate the inequality, whereas fiscal stimulus tends to equalize it. Due to the rise of inequality and populism, fiscal stimulus may be more preferred than monetary stimulus in the future. Steepeners will likely perform well under that environment.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
Opinions and statements of financial market trends that are based on current market conditions constitute judgment of the author and are subject to change without notice. The information and opinions contained in this material are derived from sources deemed to be reliable but should not be assumed to be accurate or complete. Statements that reflect projections or expectations of future financial or economic performance of the markets may be considered forward-looking statements. Actual results may differ significantly. Any forecasts contained in this material are based on various estimates and assumptions, and there can be no assurance that such estimates or assumptions will prove accurate.
Investing involves risk, including possible loss of principal. Past performance is no guarantee of future results. All information referenced in preparation of this material has been obtained from sources believed to be reliable, but accuracy and completeness are not guaranteed. There is no representation or warranty as to the accuracy of the information and Penn Mutual Asset Management shall have no liability for decisions based upon such information.
High-Yield bonds are subject to greater fluctuations in value and risk of loss of income and principal. Investing in higher yielding, lower rated corporate bonds have a greater risk of price fluctuations and loss of principal and income than U.S. Treasury bonds and bills. Government securities offer a higher degree of safety and are guaranteed as to the timely payment of principal and interest if held to maturity.
All trademarks are the property of their respective owners. This material may not be reproduced in whole or in part in any form, or referred to in any other publication, without express written permission.
