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  • Alessandro De Vito

Investment Opportunities under Different Yield Curve Regimes

Aktualisiert: Juni 24

Alessandro De Vito, Portfolio Manager

Filip Lipev, Quantitative Economist @ UBS

May, 2020




Abstract

What does the yield curve tell us and how can an investor gain insights from analyzing it when assessing potential investment ideas? This question is often on academic and professional financiers’ agenda as they assess current economic conditions and try to make an educated and well-informed forecast about the future. This paper attempts to examine how particular yield curve regimes affect the performance of different equity sectors and equity factors, also considering global macroeconomic developments (notably inflation dynamics). It provides investors with much-needed ammunition in their effort to beat the benchmark index.




Investment Opportunities under Different Yield Curve Regimes


Whenever investors try to grasp the concept of intrinsic value of any asset, they inevitably incorporate a personalized prophecy of future developments. These prophecies manifest itself in the form of interest rates, which represent a numerical proxy for someone’s predictive abilities. These interest rates and, more broadly, the yield curve act as an iterative screenplay for current and future market conditions, which filter into equity valuations through the application of discounted rates. The latter directly impact the present value of future cash flows.


Yield curve dynamics have been an important topic for professional market commentators when trying to assess business cycles and recession risks, especially in the United States. Markets’ interest gets even stronger when the yield curve starts to invert, which happens when short-term (3-month) government bond yields exceed long-term (10-year) government bond yields. This is when economic activity slows down, investors try to lock into long-term investments (pushing prices up and yields down) while the market shies away from short-term bonds amid recession fears (pushing prices down and yields up). This makes short-term borrowing less favorable than long-term borrowing for governments, firms and households – ultimately hitting economic activity. One will also understand why the inversion of the yield curve has been among the market’s favorite given its very good track record in preceding recessions (the yield curve inversion preceded each US recession since 1950) and predicting recessions (the yield curve inversion predicted all recessions in the last 50 years, with only one false-positive in 1998).


The yield curve inversion has been seen as an impressive signal for impending recession episodes (Estrella & Mishkin, 1998). Their seminal paper focused on how well the performance of various financial variables can predict recessions and pointed out that beyond the first quarter the best indicator for such purposes is the slope of the yield curve. More recently, researchers have noticed that the predictive power of the yield curve has deteriorated in recent years (Chinn & Kucko, 2010), though the relationship between the yield spread and economic growth has held up pretty well for some European countries. Some go even further, saying that there are a number of reasons to conclude that the yield curve is no longer as powerful in predicting recessions as it has been in the past (De Backer, Deroose, and Van Nieuwenhuyz, 2019). This is not to say that yield curve dynamics should be ignored by the markets going forward, but rather that one should also consider other variables (Borio, Drehmann, and Xia, 2019) to achieve a more holistic approach when assessing recession probabilities. At any rate, a consensus seems to have emerged that the yield curve inversion is among the best available indicators that market practitioners have in their toolkit for forecasting economic recessions.


Research exploring how yield curve dynamics affect recession probabilities, namely the likelihood that a recession will occur in the foreseeable future, is abundant. Yet, there is little research that tries to assess how different yield curve regimes affect the performance of different equity sectors and equity factors. Moreover, there is an even larger lack of research when one wants to incorporate factor investing into the equation. We try to fill these gaps and promote market visibility for all sorts of investors.

First, we identify four main market environments, the so-called ‘yield curve regimes’ in different countries. These include Bull Flattening, Bear Flattening, Bull Steepening, and Bear Steepening. Since these yield curve regimes cover pretty much each part of the business cycle, this provides with much-needed insight on what can happen under different scenario paths. Second, we analyze the performance of each equity sector during these yield curve regimes in each of the selected countries. Third, we then geographically zoom out and assess the performance of common factors on a more macro level. Lastly, we analyze what current global macroeconomic conditions tell us about potential inflationary dynamics stemming from the COVID-19 outbreak in an effort to assess which yield curve regime is most likely to occur next. The latter is crucially important because the conducted analysis serves as an investment compass for current and future economic realities and their most likely consequence on equity markets.



Defining and Describing Yield Curve Regimes


We decompose the yield curve into four common regimes based on the shape of the yield curve and the corresponding change in interest rates. To increase visibility, we analyze yield curve regimes based on monthly data while defining the 10-year government bond yields as the ‘long-term yields’ and the 3-month government bond yields (or equivalent) as the ‘short-term yields’. The main yield curve regimes are the following:

  • Bull Flattening: Yield curve flatten as long-term yields fall more than short-term yields amid generally falling interest rates environment;

  • Bear Flattening: Yield curve flattens as short-term yields rise more than long-term yields amid generally rising interest rates environment;

  • Bull Steepening: Yield curve steepens as short-term yields fall more than long-term yields amid generally falling interest rates environment;

  • Bear Steepening: Yield curve steepens as long-term yields rise more than short-term yields amid generally rising interest rates environment.

We apply the above framework for the last decade, with data spanning from January 1, 2010 to March 31, 2020 for the following countries:

  • United States: Largest economy and equity market in the world, global reserve currency and safe haven currency status;

  • Germany: Largest economy in EMU/European Union, a proxy for European risk-free asset;

  • Switzerland: Safe-haven currency status;

  • Italy: Major European country with regular yield mark-up to Germany.



Equity Sector Performance under Different Yield Curve Regimes


In the United States, the Bull Flattening and Bear Steepening periods are the most prevalent with each consisting of 64 months. The former is associated with the anticipation of slower economic growth and reduced inflationary pressures, whereas the latter is associated with an acceleration of economic growth and increased inflationary pressures. Both, however, show significant movements on the back-end of the curve, typically the area of the curve left untouched by monetary authorities and overwhelmingly driven by market forces (barring targeted policy initiatives).


Figure 1. US Yield Curve Regimes 2010-2020

The distribution of yield curve regimes for Germany, Switzerland and Italy is similar and reflects a higher degree of uncertainty the further out investors try to balance across the timeline. The latter goes in line with the liquidity preference theory which suggests that an investor seeks higher premium on longer-term assets if they were to sacrifice short-term ones.


Figure 2. Germany Yield Curve Regimes 2010-2020

Looking more broadly, one can see that there is a synchronized pattern visible between the shifts from one regime to another, corresponding to a more interconnected global economy. Still, Italy behaves more idiosyncratic, most likely reflecting their poor policy track record over the past decades that ultimately drove long-term growth potential sharply down.

Figure 3. Switzerland Yield Curve Regimes 2010-2020


Figure 4. Italy Yield Curve Regimes 2010-2020

Having identified the yield curve regimes and their corresponding date ranges, we are now capable to document the historical average performance for both the broad market index and each sector.


Table 1. US Equity Sector Performance under Different Yield Curve Regimes

Note. Calculated by Alessandro De Vito and Filip Lipev, Data: MSCI, Bloomberg


Table 2. Germany Equity Sector Performance under Different Yield Curve Regimes

Note. Calculated by Alessandro De Vito and Filip Lipev, Data: MSCI, Bloomberg


Table 3. Switzerland Equity Sector Performance under Different Yield Curve Regimes

Note. Calculated by Alessandro De Vito and Filip Lipev, Data: MSCI, Bloomberg


Table 4. Italy Equity Sector Performance under Different Yield Curve Regimes

Note. Calculated by Alessandro De Vito and Filip Lipev, Data: MSCI, Bloomberg


The US benchmark S&P 500 index shows their best performance during Bear Steepening periods, arguably fueled by bullish investor sentiment through rising long-term interest rates in anticipation for a rolling (and maybe overheated) economic outlook. This is often accompanied by rising inflation expectations. During Bull Flattening periods the S&P 500 is showing its worst performance, largely driven by recession fears and diminished growth prospects, leading to lower long-term yields. While this narrative seems to be consistent, every other country shows diametrical results.


Diving into the different sector performances, interesting patterns seem to appear. Like the fact that in the US and Germany across all yield curve regimes, the IT sector constantly is outperforming the broad market. We attribute this to a prevalent conviction that the IT sector is a one-fits-all economic tool.


Financials

Unsurprisingly, the financial sector (excepting Italy) outperforms the broad index during Bear Steepening regimes which is largely benefiting from a rising yield spread environment by taking advantage of the maturity transformation along the curve in their traditional banking business. It is worth noting, however, that Germany and Switzerland, subject to negative interest rates, suffer relatively to the broad market during Bull Steepening regimes. This seems to reflect the fact that they are not being able to lower interest rates below zero (on their main source of funding) as market participants would rather hoard cash, as suggested by the liquidity trap.


The same rationale holds when looking at the performance of the financial sector in phases of Bear Flattening regimes which is widely believed to be detrimental for the profitability of the banking sector. While this is true for non-negative interest rate markets like in the US, it is not for European banks. Those banking industries that can’t pass negative interest rates to their clients, do seem to profit from a Bear Flattening regime as their expenses of parking liquidity at negative rates is reduced with higher short-term yields. However, all countries – except for Italy - show negative performances during Bull Flattening regimes reflecting the more intuitive interest rate differential concept.


Italy, which has been underperforming thus far in most cases, demonstrates an excellent performance in its consumer discretionary sector relative to its benchmark. While Italy isn’t excelling in terms of productivity, they do seem to know though how to ensure customer loyalty through their monopolistic competition strategies.


Relative Performance Persistence

With a variation of the common Upside/Downside Capture Ratio, we analyzed the persistence of the relative performance of each sector during different yield curve regimes. More specifically, we calculated the ratio between each sector’s outperformance to its underperformance. This simplification helps to select or to avoid a particular sector whenever the expected yield curve regime is hard to forecast. Ignoring the IT sector, it has been discovered that the US Industrial & Discretionary sector, the German Industrial & Discretionary sector and the Swiss Materials & Discretionary sector are of particular interest. Those sectors show the most persistent overperformance to underperformance in the period analyzed.



Factor Performance under Different Yield Curve Regimes


Factor investing has become very popular among investors who seek to select their underlyings based on quantifiable traits which explain to a large part its return and risk characteristics. The six most common factors have been institutionalized and they are Size, Value, Quality (using the seminal Fama & French three-factor model) as well as Momentum, Low-Volatility and Yield. Factor investing has become a modern way to subdivide traditional alpha. This relationship is illustrated below.


Figure 5. Decomposing Alpha, Alessandro De Vito and Filip Lipev


Applying this framework, we have calculated the performance of the five most-used factors in the investment industry under each yield curve regime. Here is a summary of explanations for each factor.


Low-volatility

Investors tend to put a lower perception towards gains relative to a loss of the same magnitude, according to the prospect theory. In other words, they suffer more from a loss than a win even if the same size. Thus, investors seek investment in low-volatility equities in an effort to mitigate the effect of market downturns. Consequently, those equities often lag when the market is in a pure risk-on mood.


Yield (aka High Dividend Yield)

Warren Buffett used to say that equities are in principle bonds with a variable coupon (Fortune, 1977). A yield factor strategy captures the idea of investing in companies which demonstrates to have stable and sustainable dividends. With regular payouts, investors basically get served with a certain amount of cash in the present compared to an uncertain gain in the future.


Quality

This rather defensive factor tries to capture the attractiveness of a company by its business model and competitive advantages. It utilizes the return on equity (RoE), leverage and earnings variability to identify this factor fundamentally.


Momentum

“Never change a winning team/horse” is probably the most evident idiom to describe this persistency-based factor. Basically, this factor screens the investable universe for equities and shows risk-adjusted excess return figures (i.e. returns exceed market returns) over the past six or 12 months.


Value

Arguably the very first factor in the investment industry, which was researched and published by Graham & Dodd in 1934, followed the Great Depression. Its notion is to invest in presumably undervalued stocks, compared to the broad market. It does so with screening each sector and identifying equities that display low fundamental-based (e.g. P/E, P/B and EV/CFO) ratios.


Table 5. US Factor Performance under Different Yield Curve Regimes

Note. Calculated by Alessandro De Vito and Filip Lipev, Data: MSCI, Bloomberg


Table 6. World Factor Performance under Different Yield Curve Regimes

Note. Calculated by Alessandro De Vito and Filip Lipev, Data: MSCI, Bloomberg


Table 7. Europe Factor Performance under Different Yield Curve Regimes

Note. Calculated by Alessandro De Vito and Filip Lipev, Data: MSCI, Bloomberg


Table 8. Emerging Markets Factor Performance under Different Yield Curve Regimes

Note. Calculated by Alessandro De Vito and Filip Lipev, Data: MSCI, Bloomberg


The MSCI All-Country-World-Index, probably the most diversified equity benchmark as it represents the entire opportunity set of large- and mid-cap stocks across the globe, shows its best performance in Bear Steepening periods alongside with the US and with the same set of preconditions as described above (i.e. expectation of a roaring economic outlook and increasing inflation). Europe and the Emerging markets also demonstrate positive performances during Bear Steepening performances not ever-best though.


Immersing into the single factor performance, we have found out that the Volatility factor consistently outperforms the broad market in Bull Flattening periods – which we remember are those periods where recession fears are prevalent causing long-term yields to fall more than short-term yields. This proofs the common belief that during market turmoil investors are penalized for holding on high volatility stocks. Indisputably, in the same yield curve regime (Bull Flattening) the Quality factor performs relatively well. In the US and World (ACWI) they are even doing better during Bear Flattening periods (rising short-term yields, decreasing yield spread) which are somehow consistent with the idea of quality stocks being less leveraged, thus less affected by increasing short-term yields. In addition, those companies demonstrate to have lower earnings variability and are therefore better equipped for occasional earnings recession. Surprisingly, however, the quality play does not seem to consistently play out in Europe (underperforming the benchmark in 3 of 4 regimes), considering all political instabilities across the lion share of EUROPE namely the European Union (ex-Switzerland). Everywhere but in the US, the Value factor is outperforming the broad benchmark during the Bear Steepening yield curve regime which is together with the Bull Flattening regime the most prevalent in our analysis. The outperformance of the Value factor can easily be explained with a catch-up rally whereas investors reassess valuations and pay-up those companies lagging the sector. To sum up, the most consistent returns across all yield curve regimes are simplified as follow.

  • US: Quality & Momentum

  • WORLD: Quality & Momentum

  • EUROPE: Quality & Momentum

  • EMERGING MARKETS: Volatility & Quality



Inflation Prospects


The global economy faces severe supply and demand-side effects stemming from the Covid-19 outbreak which can lead to different inflationary trajectories going forward.


On one hand, the significant decline in global economic activity will put significant downward pressure on inflation. This will be aggravated if low or negative inflation expectations become more prevalent and ultimately reflected into inflation dynamics. The latter implies lower producer prices, which ultimately filter into the cost of consumer goods. Geopolitical fights (e.g. Saudi Arabia vs Russia) that translate into price wars over oil supply can only amplify these downward pressures on inflation. Last but not least, as investors flock into safe-haven currencies (e.g. USD, CHF, JPY), this will lead to an appreciation of currencies in these key countries, which in turn will filter into lower inflation, potentially bringing some of them into the negative territory. If an overwhelming part of the developed world faces deflation, this is likely to drive the global inflation dynamics as well.


On the other hand, one can easily contemplate a scenario where the disruption in global supply chains reduces the availability of goods, triggering inflationary pressures in some sectors (i.e. cost-push inflation). If firms struggle to resume production fast after the outbreak is brought under control, this may lead to a more permanent reduction in the supply of goods. At the same time, the unprecedented policy response across the globe in terms of fiscal and monetary stimuli, along with pent-up demand and elevated precautionary savings, may well lead to a surge in inflation if demand exceeds supply by a wide margin as the outbreak fades. As emerging markets face depreciation pressures on their currencies, this would lead to extra inflationary pressures in these developing markets. Lastly, if one sees a quick rebound in oil and other commodity prices should the global economy turn the page at a faster-than-expected pace, then this may also add up to the inflation story going forward.



Conclusion


Overall, the global economy will most likely face deflationary pressures over the short to medium-term (i.e. over the next 12-18 months), before this moves into an inflationary story. The slump in domestic demand on a global level seems to be much stronger than the supply side concerns and even if there are some relative price changes across sectors, the overall price growth will be very low if not negative for some time. Some developed countries will very likely flirt with deflation this year, especially if permanent output losses stemming from the Covid-19 outbreak were to escalate (e.g. too high unemployment, massive firm failures and bankruptcies). The bigger these permanent output losses, the stronger the scarring of the economy, i.e. difference between pre-crisis and post-crisis growth trajectory, and therefore lower inflation.


Based on this rationale and our analysis from above we see the Bull Flattening regime to prevail on a 12-18 month tactical view. This suggests that defensive sectors across all sectors and utilities in the US should outperform. As for factors, our findings suggest that Volatility and Quality factors would beat the broad market.

On a longer-term view (up to 36 months) a Bear Steepening investment outlook seems more likely, considering the inflationary pressures the world would face overall especially catalyzed by the tremendous amount of money supply created through monetary and fiscal authorities. In this environment, financial and consumer discretionary companies would likely outperform across all countries. Besides, the Value factor in the World, Europe and Emerging Markets is expected to over-perform the market under this expected yield curve regime.



References


Altavilla, Burlon, Giannetti, and Holton (2019). Is there a zero lower bound? The effects of negative policy rates on banks and firms. ECB Working Paper Series


Blackrock (2018). What the yield curve can tell equity investors. Retrieved from

https://www.blackrock.com/americas-offshore/insights/what-the-yield-curve-can-tell-equity-investors


Borio, Drehmann, and Xia (2019). Predicting recessions: financial cycle versus term spread. BIS Working Papers


Buffett (1977). How inflation swindles the equity investor. Fortune Classics

Chinn and Kucko (2010). The predictive power of the yield curve across countries and time. NBER Working Papers


De Backer, Deroose, and Van Nieuwenhuyze (2019). Is a recession imminent? The signal of the yield curve. National Bank of Belgium


Estrella and Mishkin (1998). Predicting US recessions: financial variables as leading indicators. Review of Economics and Statistics


Graham, and Dodd (1934). Security Analysis.


NT Asset Management (2019). Taking Interest Rate Risk Out of Factor Investing. Retrieved from https://pointofview.northerntrust.com/taking-the-interest-rate-risk-out-of-factor-investing-d0c13c8e03b




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