The ability of fixed income markets to predict performance for equities is almost like magic to me. Time and again, the shape of the yield curve has accurately forecast the most important driver of equity returns – future earnings growth.
According to Richard Bernstein, former chief quantitative strategist at Merrill Lynch and founder of Richard Bernstein and Associates, what bond markets are telling investors now is that the emerging-markets growth spurt is over. And, with developed markets regaining global economic growth leadership for the foreseeable future, a major portfolio overhaul will be necessary for many Canadians.
The premise behind the bond market's predictive ability is that the steepness of the yield curve – the difference in yield between two-year and 10-year bond issues – reflects a consensus view on future economic growth. The steeper the curve, the more growth is expected. When the curve is steep, banks, who borrow at short term rates and offer loans at long term rates, make more profits per loan. They are motivated to increase lending, spurring economic growth, when the yield curve steepens.
Mr. Bernstein has frequently noted that an inverted yield curve, with 10-year yields falling below two-year yields, is a reliable sell signal for equity investors. It suggests economic growth and aggregate earnings growth are set to fall.
The accompanying chart is a partial recreation of one released by Mr. Bernstein in a report released Wednesday. The trend is clear; global growth expectations are moving west.
Yield Curve Steepness: 10Y Yield minus 2Y Yield (bps)
SOURCE: Scott Barlow/Bloomberg
Brazil, Russia, India and China all have flat yield curves that suggest economic growth there is unlikely to improve. China bulls will point out that even if the Chinese economy doesn't accelerate, growth is still at high levels relative to developed markets. But asset prices rise when conditions improve. So, if China's growth stays the same, it is likely that assets are already priced for that level of growth and will not appreciate significantly.
Bond markets suggest that improving economic conditions are most likely in Portugal, Spain, Italy, Peru, the United States, Mexico and the United Kingdom.
The Canadian yield curve suggests slightly below average growth in the coming years, better than Australia and equal to the German economy. Sluggish growth projections for the resource-heavy domestic economy make sense in light of the weakening outlook for emerging markets.
The yield curve is not a crystal ball for stock selection but it does allow investors to estimate future earnings growth for the equity market as a whole. For Canadian investors, the current state of global bond markets provides more evidence that the main investing theme of the past 12 years – emerging markets growth driving high commodity prices – may have already ended.
Within the scope of their specific risk tolerance, investors have ample reason to shift portfolio weightings away from resource-based assets towards companies that benefit from economic growth in the United States and Europe.
Follow Scott Barlow on Twitter at @SBarlow_ROB.