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September 25, 2023 at 11:30 AM
What You Need to Know
- Historical equity returns have been significantly lower in one-year periods when bill yields exceed bond yields.
- Pivoting from bonds and equities into bills when the yield curve inverts has been a smart play historically, but investors need to be ready to move back when it normalizes.
- This doesn’t necessarily mean that stocks shouldn’t be part of a portfolio when the yield curve is inverted.
In a recent article, we find evidence that bond investors should prefer Treasury bills in the short run — using historical global return data, longer-term bond returns are no more likely to be lower a year from today.
What about stocks? Inverted yield curves suggest that investors are pessimistic about future economic growth, but do stock prices accurately incorporate negative future sentiment?
There is some evidence from the academic literature that, at least in the U.S., future stock performance is lowest when yield curves invert early in a recession. Bond investors appear to do a much better job of predicting when a recession is likely to occur, but stock investors appear to be caught sitting on their hands (and on valuations that don’t reflect an increasingly pessimistic reality).
This means that early in the recession when the yield curve inverts, stock valuations are higher than they should be and equity investors are subsequently punished with lower future returns. Once the recession is in full swing, valuations fall and equity investors are rewarded for accepting risk when investors require a high risk premium for buying stocks after they’ve fallen in value.
The tendency to avoid risk when valuations are most attractive reflects our own findings from investor risk tolerance surveys. Investors are most risk tolerant when stock prices are high, even when the clouds of an impending recession appear on the bond investors’ horizon. They are also most risk averse when stock prices are low, which drives higher future performance for investors who can stomach investing after a loss.
Given the limited number of yield inversion periods in U.S. data, we look at historical global return on subsequent equity performance when yield curves invert. We focus on short-term (one-year) and intermediate-term (five-year) stock returns to see whether stock investors underestimate the impact of an inverted yield curve on short-term economic conditions.
When we sort by the yield spread between bonds and bills, we find evidence that historical equity returns have been significantly lower in one-year periods when bill yields exceed bond yields, although the effect clearly decreases over time.
Similar to our previous study, these results suggest pivoting away from bonds and equities into bills when the yield curve inverts has been a smart play historically, but investors need to be ready to move back into bonds or equities when the yield curve normalizes.
Analysis
Our analysis uses data from the Jordà-Schularick-Taylor (JST) Macrohistory Database, which includes 48 real and nominal returns for 18 countries from 1870 to 2020. Economic data for Ireland and Canada are not available, which is why only 16 countries are included in the analysis.
