Inversion Indigestion: Covenant’s Weekly Market Synopsis (August 16, 2019)

August 19, 2019

Last Week Today. Argentina’s stock market fell by a remarkable -48% in U.S. Dollar terms (-30% in local currency) Monday after the current reform-minded president was beaten badly by his left-wing rival in primary elections. Keep in mind this is the same Argentina that, despite defaulting on its debt eight times in the last 200 years, was able to sell $2.75 billion of 100-year bonds to the market in 2017. | During Wednesday’s market sell-off of -3%, President Trump reportedly checked-in with the CEO’s of JPMorgan Chase, BofA, and Citigroup. The message from the bankers is that the consumer is in a good position, but trade tensions are hurting business confidence. | Speaking of trade tensions, in another round of “He Said, Xi-Said,” President Trump delayed the imposition of some tariffs until December, while China’s President Xi threatened to retaliate against the remaining tariffs scheduled for September 1st. | Japan jumped ahead of China as the largest holder of U.S. Treasury bonds ($1.1 trillion).

Financial Markets. Angst from a potent array of data points and tweets created another volatile week in the financial markets. Trade uncertainty, weak economic data from China and Germany, and a brief inversion in a critical portion of the yield curve buffeted markets as human investors and pre-programmed trading algorithms reacted forcefully to each new headline. Additionally, recession talk was everywhere this past week, from the newspapers to the radio, to the T.V., to the Internet (see the Google Trends graph below). If Charlie Brown were interviewed on CNBC, all of this doom and gloom would inevitably lead to one of his famous “Good grief” exclamations (I apologize to any of our Millennial readers as you’ll need to Google “Charlie Brown” to understand the reference).



Yet, for the second week in a row, the powerful daily ebbs and flows led to only modest declines in the major indices, such as the S&P 500 which ended down only about -1%, even as bond yields plumbed new lows. Indeed, new records were set throughout the week, including the German 10-year bund (the benchmark for European debt) reaching a yield of -0.73% on Friday; 45% of Investment Grade corporate bonds outside of the U.S. now trading with negative interest rates; the 30-year U.S. Treasury bonds reaching an all-time low of 1.91%. For specific weekly, month-to-date and year-to-date asset class performance, please click here.

Sometimes, But Not Always. Admittedly, the probability of recession is higher, but it’s not baked in the cake, even as financial T.V. pundits and their guests breathlessly discussed the yield curve inversion, over and over and over again. While it’s common knowledge that a yield curve inversion preceded every recession in the U.S., it’s not as well understood (or advertised) that every yield curve inversion has NOT resulted in a recession. In other words, the yield curve signal generates false positives. Moreover, the relationship between yield curve inversions and recessions is less pronounced internationally, arguing against the robustness of the signal.

There are also structural reasons why signals from the yield curve may not be as information-rich in today’s economy, which is a topic for another day. However, stepping around arguments for and against the quality of the yield curve signal, even if one believes this inversion will lead to a recession, good luck on timing it.   According to Goldman Sachs, in the last five inversions dating back to 1978, recessions have started anywhere from 14 months to 35 months, with a median of 20 months, following the inversion.  Investors should also note that following those five inversions, the S&P 500 rose by an average of 12% in the year following the inversions.

Nevertheless, fears of a recession, higher volatility, and favorable interest rates are causing investors to seek the safety of money market funds. Total investments in money market funds are now at levels last seen during the Financial Crisis in 2009. Now that the Fed is cutting interest rates, money market yields will no longer be as attractive, and investors will likely look for a new home for much of this money.


Source: Bloomberg LP and Covenant Investment Research.


Though a storm may be gathering on the horizon, there are legitimate rays of sunshine piercing the clouds that could prevent this slowdown from becoming a more severe situation, including:

Ray I.  The yield curve inversion is a signal that monetary policy is too tight, an early warning sign that a recession is likely only if the Fed fails to react. The Federal Reserve is no longer ignoring the market signal of the yield curve.  Nor is the Fed ignoring slower economic growth at home and abroad.  While they haven’t admitted the December rate hike was a mistake, the Fed cut rates in July. To forestall further slowing, they’ll need additional rate cuts.

Ray II. Global central bankers are once again in a coordinated monetary policy easing cycle. The Fed’s interest rate cut in July provided cover for central banks overseas to cut rates to support their economies without the nasty side effect of potential capital flight from their countries.

Ray III. The consumer remains “in the game.” Comprising approximately 70% of domestic GDP, consumers continue to spend, pushing the economy forward. Strong balance sheets, low unemployment, and rising wages augur for continued support from this critical economic growth engine.

Ray IV.  Lower interest rates are good for the housing sector.  The recent decline in interest rates is leading to an increase in the number of mortgage applications and housing start permits. Housing has been in a pronounced slump for the past six quarters, but moderating prices, wage growth, and reduced borrowing costs are reasons for optimism that housing will stabilize in the back half of this year.

Bottom Line: The yield curve inversion does not a recession make. Risks of recession are higher, but they are no longer blithely ignored by the Federal Reserve or central bankers around the globe who are actively cutting interest rates to address the global slowdown. Hopefully, Fed Chair Powell will use his speech at the Jackson Hole Economic Symposium on Friday to clarify the Fed’s monetary policy strategy. Some will argue too little too late, but for now, we’ll take the other side of the argument.


How the Mind Works Against Successful Investing – Affinity Bias

(Entry #6 in a series on Behavioral Finance)

Most of us have faced this situation: When selecting wine at a dinner with friends, we default to a well-known, expensive bottle on the menu when a lesser-known (and cheaper) bottle would be equally enjoyable. Why do we do this, or why at least are we tempted to do this? You can probably guess the answer – the more expensive wine conveys status. Said differently, people select the pricier bottle not because of its functional benefits, but because of its image-related value. This tendency to make irrationally uneconomical choices based on our belief it will affect how others perceive us or the idea that the decision reflects our values is an emotional shortcoming known as Affinity Bias.

Humans are highly susceptible to Affinity Bias, and advertisers figured out long ago how to influence consumer behavior by exploiting this frailty. Consider Nike’s advertising campaign, “Just Do It.” Nike’s advertisements didn’t highlight the research and development that went into their apparel, nor did the campaign focus on the performance of their shoes and clothing. Instead, Nike used athletes and motivational slogans to associate their purchases with the prospect of achieving greatness. As a result, Nike successfully expanded the use of its apparel beyond fitness and transformed the brand into a fashion statement.

In the investment world, Affinity Bias leads to several errors, including the portfolio phenomenon of “equity home bias.” Home bias is one of the most pervasive and consistent characteristics of portfolios worldwide in which investors discriminate against foreign stocks, choosing to invest more in companies based in their homeland, regardless of the prospects for those companies.

While home bias is not fully understood, research shows that patriotism plays a significant role as investors favoring domestic stocks gain the expressive value of supporting the “home team.” Of course, in so doing, investors forego the practical benefits of diversification (to economic growth and currency exposures) that come from investing internationally. This phenomenon is not unique to the United States.  The research paper “Patriotism in Your Portfolio”[1] documents investor behavior in 33 countries, revealing that investors in highly patriotic countries are more likely to overweight their respective domestic stocks.

Consider your portfolio allocation relative to the U.S.’s contribution to total GDP. The U.S. economy is less than 25% of global GDP, but I bet U.S. stocks dominate your portfolio. There are other considerations such as economic growth, market liquidity, accounting reliability, etc. that are natural barriers to allocating a portfolio consistent with global GDP contribution, but clearly, there are good companies outside the U.S. that can improve a portfolio’s future performance.



In addition to favoring domestic stocks, Affinity Bias leads to the following investment errors:

  • Purchasing stock in a company that produces a product you like. For example, suppose you own a Tesla or just like the look of the vehicles. Buying stock in Tesla (NASDAQ: TSLA) based exclusively on your feelings about the product does not make for a good investment thesis. Yes, famed investor Warren Buffett says to invest in products you know. However, I guarantee that Mr. Buffet will not invest in a company, regardless of his affinity for the product, unless he has a deep understanding of the company’s financial situation AND that the stock price is below his estimate of the company’s intrinsic value.
  • Self-Imposed Peer Pressure. Investing on the basis that your friends or peer group have made the same investment. People who invest for this reason don’t want to be perceived as an outsider and therefore follow the group’s lead without doing their own financial research.

Addressing Affinity Bias begins with taking a step back and exploring potential influences on your decisions. In so doing, if you find you are overly concerned about what other people will think of your choice, rather than focusing on the merits of the investment, that’s a good indication you need to clear your head and start the decision-making process again. You can also disintermediate yourself from the decision-making process by consulting an advisor. Keep in mind that advisors are human too, so it’s essential to understand their decision-making process. It should be data-focused and include both quantitative and qualitative analyses to address the common shortcomings in the human decision-making process.

Be well,


[1] Adair Morse (University of Chicago Booth School of Business) and Sophie Shive (University of Notre Dame), 2003.