Can equities outperform as the yield curve flattens?

• This article looks at what the recent repricing of the growth/inflation dynamics could mean for equities and risk assets in general
• Despite continued market volatility and a flatter US yield curve, we remain constructive on equities, with a tactical preference for cyclicals, value, and non-US equities
• However, given worsening growth expectations, relative to anticipated inflation expectations, diversification is increasingly important, and take a more balanced approach in portfolios seems appropriate
• We highlight more defensive areas of the market, which seem attractive from a diversification standpoint

The situation in Ukraine is changing rapidly. It is likely to dominate financial markets in the short term. Another concern for equity investors is the flattening in the US yield curve, which has sparked worries of an economic downturn, or even a recession. So just how should equity investors position portfolios at such times?

Following the recent developments in Ukraine, the increase in market volatility and sharp flattening of the US yield curve, we remain constructive on equities and maintain our tactical preference for cyclicals, value and non-US equities. However, in view of the recent worsening of growth expectations relative to inflation expectations, we believe that investors should strive to improve diversification and adopt a more balanced approach in portfolios. 

In this article, we discuss our views on the recent repricing of the growth/inflation n dynamics and their implications for equities and risk assets in general. We also highlight more defensive areas of the market, which seem attractively valued, and could represent diversification opportunities for investors in the current environment.

The US yield curve has continued to flatten at an extraordinary pace 

In February, equity and bond volatility continued to trend higher, reflecting the rise in geopolitical tensions and increasing concerns of a policy error by the US Federal Reserve (Fed). 

The US yield curve has continued to flatten aggressively. Between mid-January and mid-February, the curve has flattened by 41 basis points (bp), or a 3.0 standard deviation move, based on observations over the past five years. 

This sharp flattening of the yield curve suggests that markets are repricing growth risks. With Fed fund futures now discounting more than six 25bp hikes in the next 12 months, there has been increasing concerns that excessive policy tightening by the Fed could derail the economic recovery, with negative implications for risk assets.

The market may be overpricing the pace of US rate hikes 

The path of policy normalisation discounted by the market appears overly aggressive. Indeed, we remain of the view that inflation should moderate in the second half of the year, as consumer spending shifts from goods to services, and supply-chain disruptions abate. We note that the US market is even pricing an 80% chance of a rate cut after the next two years.

The outlook for central bank policy may also be clouded by geopolitical risks, which increased significantly in February as Russia attacked Ukraine. Typically, the volatility associated with such events is short-lived, and equities recover quickly. Yet, whether such risks threaten growth or boost inflationary pressures, via higher energy prices, any geopolitical conflict is another reason for central banks to tread carefully. 

Equities normally perform well when yield curves flatten, until they invert 

February’s Market Perspectives noted that equities tend to perform well during rate-hiking cycles, after an initial mild/short-lived pullback in the first couple of months following the first hike. We now explore how equities usually perform in periods of flattening yield curves.

Starting with curve inversion, a recent analysis by our investment bank’s European Strategy team showed that in the past eight US rate cycles, equity markets peaked, on average, ten months after the yield curve inverted (within a window of two to 18 months), but never before.

We also looked at how equities generally performed in the months following a flattening yield curve to levels below 100bp in the US, Europe, and globally, using data going back to 1980 (see table). With the US 10-year versus 2-year yield spread already below 50bp, we concentrated our analysis on three different scenarios of spreads declining to ranges of (i) 50bp to 100bp, (ii) 0bp to 50bp, and (iii) inverted. Those three scenarios represent 11%, 13%, and 8% of weekly observations over the period, respectively.

When the yield curve flattens to less than 100bp, history suggests that equities normally generate superior returns, as long as the curve does not invert. This is true for equity performance in absolute terms and relative to bonds in the US, Europe, and globally. It makes sense from a fundamental standpoint as, at this stage of the cycle, the Fed is usually trying to cool an economy which is growing above potential, with a strong labour market.

However, relative performance within the equity market is less clear-cut below 50bp, and varies by region. In all regions considered, cyclicals tend to outperform defensives modestly in the year following a curve spread of 50bp to 100bp. Below that level, performance is less differentiated, with the exception of the US market, where cyclicals tend to underperform defensives markedly in the months following inversion. 

Implications for equity allocation

Based on how equities have tended to perform in periods of flattening, and our belief that a recession is not imminent, we remain constructive on equities and risk assets. However, in view of the recent growth/rate scare, it appears prudent to increase portfolio diversification, and add more defensive exposure. In order to identify those opportunities, we looked for possible dislocations in the market, following the significant increase in 10-year yields.

Equities tend to perform well around hiking cycles

As discussed previously, cyclical and typically value-oriented sectors, such as financials, energy, industrials, and basic materials, tend to benefit from higher yields and inflation. Consistent with the increase in US 10-year yields, this positioning has worked well so far this year.

The MSCI World value index had outperformed growth by 15% in 2022, as of 23 February, and developed market cyclicals outperforming defensives by 4%, led by energy on the positive side (up +18%), and information technology and communication services on the negative side (down -17% and -14% respectively).

The relationship has been strongly correlated in the past, and the recent moves are consistent with historical patterns (see chart). 

However, within cyclicals, some sectors appear to have overshot, compared to their historical relationship (“beta”) with yields, while others have lagged (notably industrials).

The energy sector in particular seems to have run ahead of its fundamentals. While the sector should continue to be supported by higher energy prices (up to a certain point), inflation, and geopolitical risks, we believe it offers less value than industrials at this point in time. Should events in Ukraine broaden significantly, or become more entrenched, the energy sector would not be immune from a broad-based market sell-off.

For investors looking to increase their exposure to more defensive parts of the market, the healthcare sector appears attractive. Indeed, unlike consumer staples and utilities, which have performed better than expected given their inverse relationship with yields, the performance of healthcare has been consistent with the move in yields.

Within styles, small caps continue to stand out, both tactically and structurally. Indeed, smaller companies have lagged their larger peers, despite the rise in yields, which is unusual. On the other hand, value’s outperformance versus growth appears slightly overdone, suggesting that some consolidation may be on the horizon.