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What Can the Financial Markets Tell Us About the Future?

iStock-615253358.jpgReading the tea leaves of the economy and markets is always a complicated venture, but all the more so when different data sets conflict. One set of indicators can give a vastly different opinion than another set, and even looking at a single metric may require interpretation when the level, versus the direction, point towards opposing potential outcomes. This is even more an issue when there may be multiple explanations for every indicator’s signal.

 

As we discuss in our more in-depth paper on the subject, signals can indeed be complicated. Consider the yield curve, for example. Its steepness can tell us the direction of the economy – sometimes. In each of the past recessions going back decades, it was preceded by a yield curve that “inverted,” meaning that longer maturity bonds yielded less than shorter maturity bonds. That generally is a signal that investors expect the economy (and inflation) to slow, requiring the Fed to cut short term rates while investors demand less compensation for inflation. And investors may prefer the safety of government bonds versus riskier investments, such as stocks.

However, the reflexive logic that all recessions were preceded by an inverting yield curve does not equate to all flattening yield curves necessarily indicating a recession is imminent. Consider the graph below of the difference between the yields on ten-year U.S. Treasury notes and that of two-year notes. The lower this number is, the flatter the yield curve, and when it is negative, that means the yield curve has inverted.

We can look at the flattening yield curve now and we might even assume the economy is about to slow – until we consider that, during much of the mid- and late- 1990s, the yield curve was even flatter than it is today (and that was a period of very strong economic growth).

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So, what does the yield curve tell us today? To answer that question, we need to look at what the yield curve is correlated to. While there are many factors, of course, here, we’ll consider three different items which all explain the level and direction of Treasury yields. These include the levels of yields in other safe-haven bond markets (such as Germany); inflation expectations observed through commodities prices; or expectations for rate hikes, observed through a different set of commodities prices. We discuss these factors in greater detail in our short paper, but there are reasons why each of these explain why the yield curve is relatively flat today.

  • The European Central Bank (ECB) has been buying a large quantity of sovereign debt of countries in the Eurozone. German bond yields have been suppressed by this bond buying program, and investors have sometimes taken the proceeds of bonds bought by the ECB and invested in (higher yielding) U.S. Treasuries. That’s pulled down yields in the U.S.
  • Another issue is the potential direction of inflation, which we can observe through the ratio of copper prices to gold prices. Copper is a widely-used industrial metal, and its demand tends to move in tandem with economic activity, and its price tends to correspond, at least somewhat, to inflation.

Gold, meanwhile, is seen as a store of value, and while it is widely believed that it is an inflation hedge, gold actually has delivered its best returns only when inflation was coupled with weak economic growth, such as during the “stagflationary” period of the 1970s, or when investors become more fearful in a broad sense. (Of course, there are other periods when gold as an investment has shined.)

The ratio of copper prices divided by gold prices has been correlated with yields on the ten-year Treasury bond. Largely, the reason is that investors don’t expect inflation, reflected by copper prices, yet investors want a safe place to park their funds. This argues for lower longer term Treasury yields.

  • Likewise, we can see this same effect through a different ratio: platinum to palladium prices. Investors are placing less of a priority on using platinum as a protection against inflation – even though the economy is growing, sparking more demand for palladium. That could suggest that investors might not believe that there will be substantial inflation that is likely to trigger an aggressive Fed rate-hike campaign.

These reasons alone are sufficient to explain a flatter yield curve in a non-recessionary environment, but we can go even further. In a weak economic environment, we would expect credit spreads – the extra yield investors demand on bonds that have some risk, even if small, of default – to rise. Instead, they have fallen to quite low levels. This is not consistent with a recessionary environment.

We can also look to the equity markets. Two traditional leading metrics are subsets of broader indices. These two are rather cyclical sectors: transportation stocks and semiconductors. In the past, when these measures have underperformed the broader market by a notable amount, investors have taken note. However, both of these measures are now consistent with a growing economy.

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So, when we take a metric that on its own accord may signal economic weakness, such as the yield curve, and examine it in the context of a number of other indicators, we have a valid explanation that refutes that view. Indeed, when reading the tea leaves of the economy, one needs more than one “leaf” to complete the portrait.

Disclosure: Investing involves risk, including possible loss of principal, and investors should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions. The information contained in this piece is intended for information only, is not a recommendation to buy or sell any securities, and should not be considered investment advice. Please contact your financial adviser with questions about your specific needs and circumstances. The opinions expressed in this article are those of the author and not necessarily United Capital Financial Advisers, LLC.  The information and opinions expressed herein are obtained from sources believed to be reliable, however their accuracy and completeness cannot be guaranteed. All data are driven from publicly available information and has not been independently verified by United Capital. Opinions expressed are current as of the date of this publication and are subject to change. Certain statements contained within are forward-looking statements including, but not limited to, predictions or indications of future events, trends, plans or objectives. Undue reliance should not be placed on such statements because, by their nature, they are subject to known and unknown risks and uncertainties. Indices are unmanaged, do not consider the effect of transaction costs or fees, do not represent an actual account and cannot be invested to directly. International investing entails special risk considerations, including currency fluctuations, lower liquidity, economic and political risks, and different accounting methodologies.

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United Capital Financial Advisers, LLC (United Capital) provides financial guidance and makes recommendations based on the specific needs and circumstances of each client. For clients with managed accounts, United Capital has discretionary authority over investment decisions. Investing involves risk and clients should carefully consider their own investment objectives and never rely on any single chart, graph or marketing piece to make decisions. The information contained in this blog is intended for information only, is not a recommendation, and should not be considered investment advice. Please contact your financial adviser with questions about your specific needs and circumstances. This blog is a sponsored blog created or supported by United Capital and its employees, organization or group of organizations. This blog does not accept any form of advertising, sponsorship, or paid insertions. Certain authors of our blog posts may be influenced by their background, occupation, religion, political affiliation or experience. It is important to note that the views and opinions expressed on this blog are that of the owner, and not necessarily United Capital Financial Advisers. As a Registered Investment Adviser, United Capital does not allow any testimonials on their blog, and any comments deemed as such United Capital will remove.

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Gene Balas

Written by Gene Balas

Gene is a portfolio manager in United Capital's Investment Management Department. Gene began his career in 1989 and is a Chartered Financial Analyst with an MBA from Columbia University. His passion outside of work is weightlifting.

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