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Portfolio > Economy & Markets > Stocks

Why Advisors Should Be Watching the Yield Curve

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“Watch the yield curve,” says Jeffrey Kleintop, chief global investment strategist at Charles Schwab & Co. If the curve inverts, meaning long-term interest rates fall below short-term rates, a recession is coming, usually 12 to 18 months later, according to Kleintop, who spoke at a strategists panel at this week’s Investment Advisor Forum sponsored by Investments & Wealth Institute, formerly known as IMCA.

That would spook stocks, finally ending a long-term rally coming up on its 10th year on March 9. “The downturn could come early next year,” said Kleintop.

(Related: Foreign Stock Markets Seen as Hot Investment in 2018)

In the meantime, he recommends that investors stay invested in stocks in a diversified portfolio that includes bonds to buffer the volatility of equities and heavily weights international shares, accounting for half of an investor’s equity holdings.

“Bonds are an important buffer to the volatility to come,” and “the global correlation among the top 10 stock markets is the lowest in 20 years. Take advantage of that.”

(Related: US Stocks Will Gain, but More Slowly, in 2018, Analysts Say)

Kleintop also recommends that investors rebalance asset allocations — “bring allocations back to long-term targets to get ahead of future volatility” and rebalance among countries and sectors within equity portfolios. “We’re late in the cycle.”

Even sector rebalancing favors Europe and Asia over the U.S., said Kleintop, noting that tech stocks, especially FAANG (Facebook, Amazon, Apple, Netflix, Google parent Alphabet), which outperformed the S&P 500 by large margins, reflect a U.S. bias.

Tech stocks account for 20% of the S&P 500 but only 6% of the EAFE index, which comprises developed markets excluding the U.S. and Canada. Financials account for 21% of the EAFE index.

Both Kleintop and Katherine Nixon, chief investment officer for the wealth management business of Northern Trust, who also participated on the strategist panel, expect the bull market in stocks will continue this year. Nixon sees “strong double-digit returns and valuations extended in the U.S. and abroad” in part because “a lot of investors are playing catch-up.”

Like Kleintop, she believes a “recession will break the market, but it’s nowhere in the forecast in the U.S. or in non-U.S. markets.”

The U.S. corporate tax cuts that takes effect this year, slashing the rate from 35% to 20%, “is a huge positive” for U.S. shares primarily because much of the savings will be used for buybacks plus capital spending, which will help boost earnings, said Nixon. “You have to get investors to take advantage of rocket fuel earnings,” said Nixon, but she noted that some of good news is already priced into stocks.

Nixon and Kleintop are not too concerned about current stock valuations, which are worrying some other strategists.  “Valuations can have a big impact on long-term returns but don’t mean anything for the short term,” Kleintop said.

“Valuations represent a little headwind for U.S. stocks but … not in developed markets outside the U.S.,” said Nixon.  She particularly likes emerging market stocks, which are “at the beginning of multiyear outperformance over U.S. stocks.”

Nixon also stressed the important of fees in investor portfolios, “which can make it difficult for many active managers to outperform” market indexes.

She’s watching the spread between two-year and 10-year Treasury securities to measure yield curve, now around 55 basis points; Kleintop prefers the spread between the 3-month Treasury bill and 10-year Treasury note, now at 114 basis points.

Nixon explained that when the yield curve inverts, it signifies tighter credit conditions, “which cut off the lifeblood of the economy” and hurt stock prices.

Watching the yield curve means watching the Federal Reserve — how aggressively it hikes rates to slow the economy and rising inflation. With a new chairman as well as new “untested” board members, there could be some “miscommunication about early action,” said Nixon.

She and Kleintop are also watching how China manages its economic slowdown, which could impact Asian markets, and Kleintop has concerns about the growing number of severe natural disasters. “Investors love them” because they lead to rebuilding, which helps economic growth, but they are a problem if they represent a growing trend, said Kleintop.

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