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Market View

Investors might want to consider how select equity and fixed-income categories may perform under the economic scenarios receiving so much press this summer. 

 

In Brief

  • Relying on a yield curve inversion as a predictor of slowing growth may lead to missed investment opportunities across asset classes.
  • The initial 12 months following the last three inversions were generally positive for many asset classes, including short-term corporate bonds and tax-free municipal bonds. 
  • Lower interest rates coupled with a still strong economy have created a unique environment where the potential of both dividend growers and high-growth stocks remain in place. 

 

Summer may traditionally be seen as the “slow season” for financial markets, but since the June 21 solstice investors have had to contend with a steady stream of market-moving headlines. While the financial media focus on the inverted U.S. yield curve (particularly, on its value as an indicator of recession) and markets debate U.S. Federal Reserve (Fed) policy and the possibility of an interest-rate cut late this month, vacationing investors might want to take measure of how some key asset classes may perform under either scenario. 

Impact of Curve Inversions
The current inversion of the U.S. Treasury curve, with the 10-year bond offering a lower yield than 3-month Treasury bills, has garnered significant media attention, since such inversions have often preceded U.S. recessions in the past—but not always. Lord Abbett investment professionals have recently noted that, while recessions are commonly preceded by curve inversions, there have been numerous false signals. 

Moreover, there have often been significant lags between curve inversions and subsequent recessions. So those who orient portfolio decisions solely on when the next downturn is coming may wind up missing  investment opportunities while they wait for the recessionary shoe to drop.

Table 1 summarizes how U.S. large-cap equities, the broader bond market, investment-grade and high-yield short-term corporate bonds, and the broad municipal bond market have fared following the previous three inversions.

 

Table 1. The Initial 12 Months Following the Last Three Inversions Were Positive for Many Asset Classes
12-month returns of selected indexes following the last three yield-curve inversions on dates indicated

Source: Bloomberg. Barclays Aggregate = Bloomberg Barclays U.S. Aggregate Bond Index, which represents the U.S. investment-grade fixed-rate bond market. Short-term corporates = ICE BofA/ML 1-3 Year U.S. Corporate Index. Short-term high-yield corporates = Bloomberg Barclays U.S. Corporate 1-3 Year High Yield Bond Index. Municipal bonds = Bloomberg Barclays Municipal Bond Index.  The historical data are for illustrative purposes only, do not represent the performance of any specific portfolio managed by Lord Abbett or any particular investment, and are not intended to predict or depict future results. Investors may experience different results.
Past performance is not a reliable indicator or guarantee of future results.

 

As Table 1 illustrates, the initial 12 months following the last three inversions were generally positive for many asset classes, including short-term corporate bonds and tax-free municipal bonds. As we all know, past performance is no indication of future results.

Impact of Falling Rates
Historically, falling rates have been associated with equity market uncertainty. But high-quality dividend growers (stocks of companies with a history of consistently paying and growing their dividends) have tended to be among the best performers in such an environment, helping to mitigate volatility and providing investors with a relatively attractive income stream. 

Dividend growers tend to be blue-chip companies with stable businesses whose stocks have a history of not only weathering bouts of volatility but also participating in market rebounds. Naturally, investor demand for these equities tends to increase during periods of uncertainty.

 

Table 2. Historically, Dividend Growers Have Performed Well in Declining-Rate Periods
Performance of dividend growers during the three most recent periods of declining interest rates.*

Source: Lord Abbett: Dividend Growers are defined as companies in the S&P 500® Index or S&P 400® Index that paid a dividend and increased their yearly dividend payout for 10 consecutive years.  *Measured by a decline of 50 basis points or more on the 10-year Treasury yield since 2016.

 

A Unique Period?
As we’ve mentioned elsewhere, we do not believe a U.S. recession is imminent. There are simply few if any economic data points signaling a recession in the near term. But we cannot rule out the possibility of a rate cut when the Federal Open Market Committee (FOMC), the policy setting group of the Fed, meets again on July 30-31.  With the U.S. economy still chugging along, such a rate cut might be justified by the Fed as an insurance policy against slowing economic growth outside of the United States.

This could create a unique falling-rate environment – one where supportive monetary policy drives rates lower while moderate economic and earnings growth in the United States continue to support equities. This potential outcome could favor another category of equities: high-growth stocks, for two reasons:

  • Growth stocks tend to be long-duration investments by their nature with investors pricing in years, if not decades, of future growth into the share prices of these securities. Lower long-term interest rates make the long-term return potential of these stocks more attractive as a result.
  • Meanwhile, a backdrop of moderate growth in U.S. gross domestic product and corporate profits tends to make the earnings and revenue growth potential of the fastest-growing stocks relatively attractive to investors.

Summing Up
With the financial media focusing on the possibility of a U.S. recession (using the inverted yield curve as a predictor) and markets anticipating a Fed rate cut sometime in 2019, investors need to take stock of the investment opportunities under both scenarios. An inverted yield curve, however, sometimes presents a false signal of recession and, given the strength of most U.S. economic indicators, we are not among those who believe that a U.S. recession is imminent. Relying on a yield curve inversion alone as a predictor of slowing growth may lead to missed investment opportunities across asset classes.

Moreover, declining interest rates coupled with a still strong economy creates a unique falling-rate environment where the potential of both dividend growers and high-growth stocks remain in place.

 

A Note about Risk: The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. Fixed-income investments are subject to various other risks including changes in credit quality, market valuations, liquidity, prepayments, early redemption, corporate events, tax ramifications and other factors. Lower-rated securities are subject to greater credit risk, default risk, and liquidity risk. Credit risk is the risk that debt issuers will become unable to make timely interest payments, and at worst will fail to repay the principal amount. Although U.S. government securities are guaranteed as to payments of interest and principal, their market prices are not guaranteed and will fluctuate in response to market movements.  The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of particular companies and/or sectors in the economy. While growth stocks are subject to the daily ups and downs of the stock market, their long-term potential as well as their volatility can be substantial. Value investing involves the risk that the market may not recognize that securities are undervalued, and they may not appreciate as anticipated. Smaller companies tend to be more volatile and less liquid than larger companies. Small cap companies may also have more limited product lines, markets, or financial resources and typically experience a higher risk of failure than large cap companies. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market.

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This Market View may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Statements concerning financial market trends are based on current market conditions, which will fluctuate. There is no guarantee that markets will perform in a similar manner under similar conditions in the future. Past performance is not a guarantee or a reliable indicator of future results.

Treasuries are debt securities issued by the U.S. government and secured by its full faith and credit. Income from Treasury securities is exempt from state and local taxes.

basis point is one one-hundredth of a percentage point.

A bond yield is income earned from a bond.  In cases where the bond pays periodic interest, the yield equals the interest collected.  Where a bond is sold at a discount on the par value, it equals the difference between the purchase price and amount received on the bond’s maturity date, otherwise known as the yield to maturity.  

Dividends are not guaranteed and may be increased, decreased, or suspended altogether at the discretion of the issuing company.

Dividend yield is equal to the dividend divided by the stock price. Dividend yield is one measure of a stock's value. A high dividend yield may indicate that a stock is relatively inexpensive.

Dividend policy: A stock is classified as a dividend payer if it paid a cash dividend any time during the previous 12 months, a dividend grower if it initiated or raised its cash dividend at any time during the previous 12 months, and non-dividend payer if it did not pay a cash dividend at any time during the previous 12 months.

Duration is the change in the value of a fixed-income security that will result from a 1% change in market interest rates. Generally, the larger a portfolio’s duration, the greater the interest-rate risk or reward for underlying bond prices.

Term premium is a gauge of the level of risk inherent in holding a longer-term bond versus a series of shorter-term securities. It represents the estimated risk embedded in a longer-maturity bond that is determined by the difference between the actual yield and the “risk neutral” yield (represented by rolling a series of shorter-term securities extending to the same maturity at current rate expectations).

A yield curve is a line that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates.

The S&P MidCap 400® Index, more commonly known as the S&P 400, is a stock market index from S&P Dow Jones Indices. The index serves as a barometer for the U.S. mid-cap equities sector and is the most widely followed mid-cap index.

The S&P 500® Index is widely regarded as the standard for measuring large cap U.S. stock market performance and includes a representative sample of leading companies in leading industries.

The ICE BofA/ML 1-3 Year U.S. Corporate Index is an unmanaged index comprised of U.S. dollar denominated investment grade corporate debt securities publicly issued in the U.S. domestic market with between one and three year remaining to final maturity.

Source:  ICE Data Indices, LLC (“ICE”), used with permission. ICE PERMITS USE OF THE ICE BofAML INDICES AND RELATED DATA ON AN "AS IS" BASIS, MAKES NO WARRANTIES REGARDING SAME, DOES NOT GUARANTEE THE SUITABILITY, QUALITY, ACCURACY, TIMELINESS, AND/OR COMPLETENESS OF THE ICE BofAML INDICES OR ANY DATA INCLUDED IN, RELATED TO, OR DERIVED THEREFROM, ASSUMES NO LIABILITY IN CONNECTION WITH THE USE OF THE FOREGOING, AND DOES NOT SPONSOR, ENDORSE, OR RECOMMEND LORD, ABBETT & CO. LLC., OR ANY OF ITS PRODUCTS OR SERVICES.

The Bloomberg Barclays U.S. Aggregate Bond Index represents securities that are SEC-registered, taxable, and dollar denominated. The index covers the U.S. investment grade fixed rate bond market, with index components for government and corporate securities, mortgage pass-through securities, and asset-backed securities.

The Bloomberg Barclays U.S. Corporate 1-3 Year High Yield Bond Index is the 1-3 year component of the Bloomberg Barclays U.S. Corporate High Yield Bond Index.  It is a market value-weighted index which covers the U.S. non-investment grade fixed-rate debt market and is composed of U.S. dollar-denominated corporate debt.  

The Bloomberg Barclays Municipal Bond Index is a rules-based, market-value-weighted index engineered for the long-term tax-exempt bond market. The index is a broad measure of the municipal bond market with maturities of at least one year.  To be included in the index, bonds must be rated investment-grade (Baa3/BBB- or higher) by at least two of the following ratings agencies: Moody's, S&P, Fitch.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

The credit quality of the securities in a portfolio are assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor’s, Moody’s, or Fitch, as an indication of an issuer's creditworthiness. Ratings range from 'AAA' (highest) to 'D' (lowest). Bonds rated 'BBB' or above are considered investment grade. Credit ratings 'BB' and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer's ability to pay interest and principal on these securities.

The information provided herein is not directed at any investor or category of investors and is provided solely as general information about our products and services and to otherwise provide general investment education. No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as Lord, Abbett & Co LLC (and its affiliates, “Lord Abbett”) is not undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity with respect to the materials presented herein. If you are an individual retirement investor, contact your financial advisor or other non-Lord Abbett fiduciary about whether any given investment idea, strategy, product, or service described herein may be appropriate for your circumstances.

The opinions in this Market View are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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  Market View

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