It’s important firstly to understand that markets work in a cycle, similar to (and somewhat connected to) the economic cycle.
They follow four distinct phases which are; boom, slowdown, recession & recovery.
There is a lot of discussion at the moment as to which phase we are in and, as usual, there is an economist for every day of the year, each with a different view. Certainly in the first quarter of the year it appeared that we are in slowdown and as records will show you it was the worst first quarter results for the UK & US since 2008. But come April, everything had bounced back again – and investors were piling into to equities.
So it’s all good, right?
Well, maybe but maybe not.
Are there any indicators?
Yes.
The most obvious indicator is something known in technical terms as a bond yield curve.
Now to understand this, let me just show you some quick diagrams with a simplified explanation:
A bond is an investment vehicle that pays a fixed rate of interest known as a coupon.
The yield of the bond is the true rate of return when compared to its price and is worked out by dividing the coupon by the price. So for example a bond paying a coupon of 5% which is valued at £110 has a yield of 4.55% (5 / 110 x 100). If the value increases to £130 then using the same formula our yield falls to 3.85%. This is because price and yield have an inverted relationship to each other.
So, when investors are confident, and the economy is growing, they will demand an additional yield for longer maturing bonds because of the additional risk of the unknown future. This creates a normal bond curve like the one above.
But this not what our bond yield curve looks at the moment.
As investors buy and sell bonds to flatten the yield curve, they are demonstrating through their behaviour that they are worried about the outlook of the economy. As a result, they prefer to have their money tied up longer in safe investments and demand less of a return for doing so.
This is what our yield curve looks like at the moment:
The one step further to this is the dreaded inverted yield curve which indicates tough economic times ahead and suggests we would be entering a recession.
In the last 25 years there have been two occasions where we have had inverted yield curves – in 2001 just before the dot.com bubble burst, and again in 2007 just before the financial crisis.
Is the investment bubble about to burst?
You know, we seem to forget that things work in cycles.
I put it down to some sort of mechanism in our brains which conveniently forgets that markets cannot continue to grow indefinitely. Eventually they must cool and even reverse. It is natural, and believe it or not good, for the markets to do so.
The question is whether we have reached that stage now after what has basically been close to ten years’ worth of continued growth or whether we still have another good few years before the inventible happens?
Should we be worried?
The fact that we have a flat yield curve would not necessarily mean that it would proceed to being inverted and thus a recession. In fact there was a period from the early 1990’s until 1997 when the yield curve was very flat – but markets were buoyant and people made money.
But it is the trend that is worrying.
The trend since 2009/10 has been going only one way, and this is what has analysts concerned that we are heading into slowdown and recession.What all this data is trying to tell us is that the market is already beginning to price in expectation of a bubble bursting, which strangely in itself can be a self-fulfilling prophecy.
Don’t Panic!
Ultimately, if everyone could predict the cycle accurately then I wouldn’t be writing this blog and the entire investment world would look a little different.
The cycle is part of the natural order and is essential for market growth (as strange as that may sound). But what most analysts can agree upon is that the days of ‘easy money’ (whatever that means) are over and volatility is going to be the new norm.
And remember the small print – investments can go down as well as up.