Let's Get Cyclical; Cyclicals Respond to Long Term Yield Curve Steepening
Those scary words “yield curve inversion” are being bandied about in the headlines by the press these days. Bad news sell papers, of course, but prudent investors should look beyond the headlines. The latter often don’t do justice to the phenomena supposedly being explained.
What part of the Treasury yield curve is inverting seems to matter. And right now the U.S. Treasury 3- months bill to 10-year note is a negative 5 basis points. But, as I’ve noted here before, it’s the 10 year-30 year bond yield curve that gives the more accurate market signal historically. The front end is getting all the media attention and shouting but the back end is where investors should focus.
The 10-30 yield spread has actually been widening, leading to a steepening yield curve, which is salutary for the economy in general and for cyclicals in particular, as we’ll see below. Today that spread is about 52bps compared to 10 bps about one year ago.
Now the widening inversion of the front-end of the yield curve is a good news/bad news story. As I noted a few weeks ago, the first Federal Reserve rate cut, during a US expansion, sees explosive gains in equities (~18% over 9 months). However, an inverting curve also speaks to the growing global economic stresses from the trade war. Some of the global growth data is soft. Despite that, and more importantly, the long end of the yield curve has steepened sharply and is now the steepest in more than 3 years. That is a strong cyclical signal.
A study done in 2017 by Fundstrat Global Advisors shows the long-term yield curve, as defined by the 30 yr-10 yr, leads the trends in the manufacturing survey from the Institute for Supply Management (ISM) by 16-18 months. Indeed, since that study was published, the long-term yield curve has done a good job forecasting inflection points in the ISM with about a 16-month lead.
Why is that? That curve indicates the expected return of long-term capital investment; hence, a flattening signals slowing growth but a steepening creates investment incentives. The long-term curve is a more important business cycle indicator and is also a proxy for “return on long-term investment”—hence, a steepening spread signals economic growth set to re-accelerate.
Currently, that yield curve suggests to me the ISM will fall towards 49-50 bps sometime in 3Q19 but then rise into 2020. As noted above, the spread saw a trough in June, 2018, which suggests to me that ISM will fall into 3Q19 and bottom perhaps in September or October at around 49-50. While this might trigger some investor anxiety about the business cycle, I expect the weakness to be transitory, assuming the global trade war does not further escalate.
More importantly for investors, however, this signal points to a sharp rise in ISM throughout 2020. In particular, this move back up, in my view, is explaining the outperformance of cyclical stocks (see table below), which respond to both the steepening curve and to a rising ISM. If purchasing managers’ indexes are in fact bottoming and on the rebound, then cyclicals are the sectors to stick with.
Given the front end yield curve inversion, investors might want to be defensively positioned, but the long term yield curve and an expected rise in ISM strongly argue for being overweight cyclical stocks.
What could go wrong? The biggest risk to my view remains an external shock from political events, which is difficult to predict and not fundamental. Topping that list logically are: the China/US trade wars; the threat of a hard Brexit in October; potential military conflict in the Middle East, such as between Iran and the U.S., and the upcoming 2020 elections. President Trump remains at the focal point for three of the four points.
Bottom line: My yearend Standard & Poor’s 500 index target remains 3,100, especially given the Fed is expected to cut in the second half of 2019. The following are 18 Cyclical stocks I expect to benefit from the upcoming ISM upturn in 3Q19. The tickers are BKNG, TPR, GM, LMT, NSC, MMM, CVX, XOM, PSX, COF, RE, BLK, MSFT, CSCO, ADP, NUE, FB and GOOG.
Per FS insight
** Performance is calculated since strategy introduction, 1/10/2019
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