Exits and Inversions

The last few weeks have seen uncertainty rearing its ugly head yet again in geopolitics and the financial markets. In Britain it was heightened disfunction related to looming Brexit deadlines. Here at home it was the yield curve and recession fears. Since the past few days have seem some notable headlines on both issues, let’s take a few minutes to review and discuss potential investment implications.

Brexit – Britain’s exit from the EU, as you’ll recall, was the result of a 2016 referendum in the U.K. asking a simple question: “Should the United Kingdom remain a member of the European Union or leave the European Union?” A political melee ensued and led to the so-called “Leavers” beating out the “Remainers”, largely on geographic and socio-economic lines. For the better part of three years now, the Prime Minister and parliament have been scrambling to figure out how to accommodate the will of the people without torpedoing their economy in the process.

The original deadline to leave the EU was this coming Thursday. With no deal in sight late last week an extension was granted by the EU, but only for two weeks until April 12th. The primary concerns about the whole process center on a seeming lack of political will and ability on the part of the prime minister and members of parliament to build consensus.

As I write this, members of parliament are actively trying to work around the prime minister to come up with their own exit deal. If they can, the EU has said it would lengthen the extension to May 22nd. Will that be enough time, given they’ve had over 1,000 days to get a deal done?

According to various analysts, the three most likely outcomes at this point are that 1) the U.K. hammers out a deal that few people are happy with but is acceptable to the EU, or 2) can’t come up with a deal and enters a so-called “Hard Brexit” by leaving without a plan, or 3) decides to put the kibosh on the whole Brexit process, perhaps sending the issue back to voters who, presumably, would vote to “Remain” simply to stop the political merry-go-round.

Whatever ultimately happens is unlikely to have much direct impact on the U.S. but is bound to roil financial markets. Does this mean we should sell investments now and run for cover? No. It means being mentally prepared for an uncertainty-induced short-term spike in volatility that markets would likely quickly recover from. Also, and all kidding aside, it’s a good time to remind ourselves that for all our political issues here at home, at least we’re not in the U.K.

The Yield Curve – I’ve written previously about the importance of the yield curve as a recession indicator. As a refresher, the curve measures the difference in yield (investment return) on bonds of different maturities, from three months out to 30 years. While there are a variety of different curves to watch within this spectrum, market watchers tend to focus on two in the Treasury bond realm in particular: the difference between the 2yr and 10yr, and the 3mo and 10yr Treasury.

While the differences in yield have been shrinking for some time now for a variety of reasons, they had not yet “inverted”, or reached the point where short-term bonds were yielding more than long-term. Or, they hadn’t until last Friday. The 3mo and 10yr curve inverted, with the 3mo now yielding 2.46% versus the 10yr yielding 2.43% as of this writing. Sounds like a tiny difference, right? It is, but this inversion is also a near-perfect predictor of a recession in the offing.

Historically, an inverted yield curve has indicated a recession coming in about a year or so, so it’s not necessarily imminent, but the timing is of course unknown. The curve could also change and no longer be inverted, given that much of what precipitated the move in bond yields last week was due to Brexit concerns and less about problems in our own economy. So, many sets of eyes will be anxiously waiting to see if the inversion is merely fleeting or if it’s truly a sign of things to come.

What to do if the curve stays inverted? The optimist might see more buying opportunities in the future. The realist would start preparing for the clouds in the distance. The pessimist might head for the hills. Finding balance between all three is probably the best thing.

For example, it’s wise for more conservative investors to consider paring back stock market exposure during the coming months. For example, maybe someone with a 50% allocation to stocks trims back to 40% (not to 0%). This would need to be based on proper planning and is subject to all sorts of caveats, but the idea is to focus on risk reduction while acknowledging you won’t get the timing just right.

Have questions? Ask me. I can help.

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