The recent volatility in the financial markets, whilst undoubtedly unsettling, provides an opportunity to reflect on what has fundamentally changed.

There are various reasons behind the recent global falls in equity values, not least to do with inflated prices for AI connected stocks, as we wrote about in a recent article.

Possibly the greatest driver, however, is the recent decision by the Bank of Japan to raise interest rates, leading to the unwinding of what is called the Yen carry trade (some of which probably had investments in Tech stocks), exacerbated by low levels of summer trading, unduly influencing markets.

Times of forced selling by short-term players such as these can however create opportunities for long-term allocators. As the great Warren Buffet once quipped…

 “Every decade or so, dark clouds will fill the economic skies, and they will briefly rain gold. When downpours of that sort occur, it’s imperative that we rush outdoors carrying washtubs, not teaspoons”.

It is therefore important at times like these to maintain a multi-year investment horizon and to view the current market environment as an opportunity.

Since October 2022, a remarkable phenomenon has unfolded in the financial world: the 3-month US Treasury yields have consistently topped 10-year yields, marking a historic 22-month inversion of the yield curve. As central banks are in a position to adopt less restrictive monetary policies, the yield curve is poised to steepen and even become positively sloped again.

But what does this rather complex sounding jargon of inverted yield curves mean for markets, and how can investors adapt to this new investment landscape?

Technically speaking, the steepening of the yield curve is a complex dance influenced by the interplay between short-term and long-term yields. In the US Treasury market, the anticipation of a Trump presidency has fuelled expectations of a steeper yield curve, driven by the prospect of tax cuts, immigration restrictions, tariffs boosting economic activity, and, ultimately, inflation.

In fact, this outcome may not be very far from that implied by Donald Trump’s Democratic contender, current Vice President Kamala Harris, and her very different and expansionary fiscal policy plans.

As investors seek protection from the erosive effects of inflation, they demand higher yields from bonds, keeping long-term yields elevated. At the same time, a key part of the trade has also been the expectation that the US Federal Reserve (Fed) will soon start cutting its interest rates as inflation moves towards its target, which should pull yields lower, especially at the short end of the curve.

So, how should investors navigate this shifting terrain?

History suggests that Fed easing cycles have typically buoyed equities, particularly in the (admittedly) rare environment of accompanying robust economic growth and low recession risks. During such periods, equities have delivered impressive returns, with an average gain of around 20% in the 12 months following the initial rate cut – provided no recession ensued.

Equities tend to perform well when the yield curve steepens, especially when driven by rate cuts

Source: Bloomberg Finance L.P. / Julius Baer Investment Writing. The chart uses monthly data from December 1984 to July 2024. Interest rate cuts without recession: 1984, 1987, 1995, 1998. IG = investment grade; p.a. = per annum. Past performance and performance forecasts are not reliable indicators of future results. The return may increase or decrease as a result of currency fluctuations.

The likely macroeconomic outlook is for slower but still solid growth in the second half of the year, with limited recession risks over the next 12 months and inflation continuing to normalise, suggesting a supportive environment for equities.

As the yield curve steepens, it looks very likely that the ‘free lunch’ in money markets is about to end

Investors may therefore want to adapt their fixed income portfolio accordingly by maintaining some exposure to long-dated high-quality bonds for hedging and diversification purposes, together with lower-quality, shorter-dated bonds to capture some additional yield. Long-duration positions with a purely speculative capital gain objective may be sold after the recent drop in yields. Entry levels into riskier segments such as US high yield have already improved significantly following the events of recent days.

In equity markets, cyclical sectors are poised to benefit disproportionately from a steepening yield curve in a solid economic environment. Banks in both Europe and the US have also historically outperformed the broader market around 80% of the time during periods of yield curve steepening.

Small-cap stocks, carrying more floating-rate debt (which allows borrowing costs to adjust with changing interest rates) than their larger counterparts, tend to thrive in the initial stages of a rate-cutting cycle. Additionally, they could be positively impacted by deregulatory measures. Quality mid-caps, which offer a mix of stability and growth potential, also present a compelling diversification strategy for investors seeking alternatives to large-caps in an environment characterised by political uncertainty.

In conclusion, the steepening of the yield curve marks a significant shift in the investment landscape, creating opportunities in attractively valued parts of the equity market that have lagged so far this year, such as small and mid-caps and cyclical sectors. As inflation and real yields move closer to their historical averages, investors must also reassess their fixed income strategies. By embracing this new reality and adapting their portfolios, investors may take advantage of opportunities in a world where the yield curve is likely to be on its way back to normal.

And finally, in case you may be worrying about timing an investment into the markets, to quote the great Warren Buffet,

“Every decade or so, dark clouds will fill the economic skies, and they will briefly rain gold. When downpours of that sort occur, it’s imperative that we rush outdoors carrying washtubs, not teaspoons”.

The key here is that volatility creates opportunity.

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