Global growth has been slowing throughout most of 2019. Although the US economy has achieved full employment and consumer-related data is still robust, fears it will slow below potential growth have been increasing across financial markets, largely due to trade tensions between the US and China.
Europe has its own housekeeping issues and continues to face persistently low growth and inflation, which, during 2019, nudged the European Central Bank to reintroduce a more open-ended quantitative easing programme and cut deposit rates further into negative territory. As a result, we now have approximately US$16 trillion of bonds globally with a negative yield and some markets (like the US) are periodically showing an inverted yield curve. The inversion of the US yield curve has recently sparked debate across the investment industry of a looming recession. History has shown us that recessions post-World War II were preceded or signalled by a yield curve inversion.
The yield curve
The yield curve is a graphical representation of prevailing market interest rates (yields) for bonds of different maturities, usually government bonds. Shorter-dated bonds tend to reflect government’s current monetary policy stance, while longer-maturity bonds tend to reflect market expectations of future inflation and the resulting path of interest rates.
Yield curve inversion prior to recession?
To illustrate why the yield curve usually inverts before recession, let’s consider the example of the yield curve representing monetary policy expectations. If market participants expect growth to slow down in the near future, they start pricing in higher probabilities of upcoming reductions in interest rates by Central Banks to support economic growth. This results in long-dated bond yields decreasing by a higher margin than short-dated bonds – so the yield curve flattens.
The extent to which the interest rates fall is a function of the length and severity of economic slowdown expected by market participants. If a recession is anticipated, participants would price in more pronounced interest rate cuts by central bankers using countercyclical monetary policy to stimulate the economy – cutting interest rates to encourage investors and businesses to borrow for growth. In this case long-maturity bond yields can decrease to such an extent that they fall below short-maturity bonds, the phenomenon called yield curve inversion.
Historically, an inverted yield curve successfully signalled a recession six to 18 months before it happened, justifying recent debates around whether a recession in the US is looming. US 10-year bonds (the longer dated government bonds) are trading at 1.7% as at 30 September.
How does this impact local investors?
Whether or not a recession unfolds in the short term, recession fears in global markets increase volatility levels. Volatility leads to risk aversion, causing investors to sell off risk assets such as equities and emerging market currencies and debt. Volatility also leads to a flight to quality as investors reallocate capital to safe-haven assets such as developed market government bonds. This explains the rally we recently experienced in these assets, where some of these government bond yields decreased (prices increased) to an extent that even the longest-dated (30-year) government bond yields were negative. This means an investor holding these negative-yielding bonds to maturity, is effectively paying the government to invest money instead of the other way around.
Investors do however tend to balance this need for safety with a search for positive yield elsewhere. Emerging market bonds tend to offer attractive positive yields, and so the extent of any sell-off of these assets as recession fears mount is limited. Instead, we may experience capital flows into these markets.
As an emerging market, South Africa offers compelling bond yields, with nominal 30-year bond yield hovering around 10%, effectively delivering real return of 5.5% (considering current inflation rates). Given the Sarb’s credibility and the market view that our central bank will keep longer term inflation around the 4.5% level, these real rates stand out as an investment opportunity compared with SA’s emerging market peers and the low-to-negative developed market bond yields.
There are local risks around the strained fiscus and persistently low growth which could lead to ratings downgrades (although our view is that this is unlikely) and a potential sell-off in bond yields. However, we believe the accommodative global monetary environment and relative valuation of SA bonds provide some potential protection against a major sell-off in our market.
Sylvester Kobo, fixed income portfolio manager at Stanlib.