What to Expect from an Inverting Yield Curve

Before we kick off our long-awaited follow-up to our Setting the Stage for Upcoming Rate Hikes issue published way back on Feb 20, seemingly eons ago, given how the world has since changed, I'd like to share some related thoughts and make you aware of upcoming changes to our Factor Spotlight newsletter.

This week's featured coverage follows the link table below this section for those readers especially anxious to jump directly into our analysis of the inverted yield curve.

First off, I want to thank our readers for the overwhelming response and enthusiastic feedback about our Factor Spotlight series focused on the ramifications of the crisis in Ukraine on investors and increasing evidence of a newly emerging global economic order. One of our primary goals for Factor Spotlight has always been to provide timely insights into issues impacting the investment community. Russia's invasion of Ukraine on Feb 24 was a game-changer requiring all hands on deck to analyze and publish our initial conclusions three mornings later.

Our analysis seems to have struck a chord. While there has been an avalanche of related coverage in the financial media, we're hearing that much of it offers minimal practical use to investors. As a result, many of our readers have been reaching out to us with concrete questions about evaluating their portfolios and better understanding the shifting risks and how best to mitigate them. We continue to stand by and encourage you to reach out with any questions and concerns you may have about your portfolios.

Also, because we're being asked about this more often, I'd also like to point out that, with few cited exceptions, our team of market analysts generates each week's Factor Spotlight content exclusively using the Omega Point platform. A fast turnaround is made possible by the platform's ability to run various simulations at extremely high speeds. In addition, our integrated provider ecosystem allows us to apply and test multiple models from different providers to hone our analysis. So when it comes to Factor Spotlight, we are both users and developers of our product; it's a reliable part of our workflow, and we take advantage of the same benefits as our customers.

We've been publishing Factor Spotlight almost every week over the past five years. Before that, we published monthly, with our first issue sent to a grand total of 98 recipients one fine Monday(!) in March of 2016. I am proud and grateful that my original musings about the then little-known world of factors have expanded in scope and reach to help increase awareness about their utility across the far reaches of the investment community.

But, like with all good things that have outgrown their original purpose, it is time for a change. So over the next several weeks, we will be sending out an abbreviated format of Factor Spotlight while we update the layout, recurring charts, tables and adjust the focus of Factor Spotlight. We anticipate having our new issue ready in early May.

In the meantime, and with macro top of mind for most investors, I wanted to direct our readers to an article we had co-written with our partners at Quant Insight titled: Macro Themes Moving Markets More than Ever in the latest issue of Regius Magazine. Our commentary begins on page 12, but we encourage you to check out the rest of the publication, which offers unique and varied perspectives from leading experts on emerging megatrends relevant to today's investors.

Lastly, for those readers who may have missed one or more Factor Spotlight issues in our previous series on the crisis in Ukraine and emergence of a new economic order, we’ve included the links below for your convenience.

After the jump, we kick off this week’s main coverage...

Date/Title

‍2/27/2022- QUANTIFYING THE IMPACT OF RUSSIA’S INCURSION INTO UKRAINE

‍3/06/2022-YOUR EXPOSURE TO THE NEW ECONOMIC ORDER

‍3/13/2022-YOUR EXPOSURE TO THE NEW ECONOMIC ORDER - PART II

‍3/20/2022-YOUR EXPOSURE TO THE NEW ECONOMIC ORDER - PART III

‍3/27/2020-MACRO FACTORS ARE DRIVING MARKET SURPRISE

HERE WE GO...AGAIN?

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The Russia-Ukraine crisis has only exacerbated inflationary woes as hawkish central banks are aggressively starting to attack inflation. However, this creates significant concerns around the hawkish Fed moves, throwing the economy into recession. This market sentiment is evident in the recent inversion of the yield curve, where long-term rates are lower than short-term rates - this is a traditional sign that the market is starting to price in recessionary risks. Given the state of the economy and the yield curve, it's never been more timely to use historical factor analysis to understand what parts of investor portfolios are most susceptible to headwinds.

Analyzing The Most Recent Inversion: Sep 2017 - Oct 2018

As we noted in our last piece on the topic, the historical period that we’ll simulate is Sept 2017 through Oct 2018.

Rather than looking at what specifically happened to individual stocks or market indices during that period, we will apply the factor movements during that period (essentially the market DNA) in today's market environment.

How will we do this?

By taking the current exposures of major ETFs (below) to the same set of factors and multiplying those exposures by the factor returns between 9/2017 - 10/2018, we can simulate the future for the same ETFs assuming similar behaviors in the factors.

To more clearly see the impact of the factor moves like growth, value, and sector moves, we show the estimated return of the ETFs with and without the market.

Energy and Tech may benefit most

Based on our simulation, we see that XLE ranks highest based on total returns. However, we need to take caution with this result. First, recall the caveat we mentioned in part 1that inflationary pressures are currently much different from those in 2017-2018. In particular, we didn't have such a heavy run on oil, nor were so many parts of the globe facing an energy crisis due to supply chain interruptions from the sanctions on Russian oil.

Tech and Large Cap Growth may also help boost performance for investor portfolios

Materials, Financials, Cons Staples, Real Estate, and Utilities are among the segments that stand to lose the most based on their current factor exposures.

As events progress, we will continue to follow the paths of the factors to assess how closely linked they are to the 2017-2018 periods or whether prior inversion periods are more appropriate analogies for the factor behaviors.

If you are interested in analyzing the impact of the yield curve inversion on your portfolio or would like to explore our methodology further, please don't hesitate to reach out.

US & Global Market Summary

US Market: 03/28/22 - 04/01/22

• The Dow fell 0.1% for the week, snapping two straight weeks of gains, while the S&P 500 and Nasdaq gained for a third consecutive week, advancing 0.1% and 0.7%, respectively.
• On Thursday, all three major indices fell to close out the first negative quarter for stocks in two years.
• The Labor Department’s employment report for March revealed that the U.S. economy created 431,000 jobs in March, and the unemployment rate fell to 3.6% from 3.8%.
• Following the Jobs report, U.S. Treasury yields jumped, and the yield curve between two-year and 10-year notes inverted for the third time in a week.
• The S&P Global U.S. Manufacturing Purchasing Managers’ Index for March was 58.8, its most significant one-month improvement since last September.
• U.S. benchmark West Texas Intermediate crude fell below $100 per barrel as the Biden administration pledged to release more strategic oil reserves.
• U.S.-listed Chinese stocks jumped on Friday after a report that China considered sharing company audits with foreign regulators.

Regards,
Omer