Bond Yield Curves - Hyperion and Tree Article Series

[HyperionTree]

Hi all, long time no see!

One of the more interesting news is that the yield curve for the Chinese government bonds had inverted.
https://www.ft.com/content/28ef6df6-36d7...23f8c0fd2e
Quote from article: "The yield on Chinese five-year government bonds hit its highest since 2014 on Friday, as tight liquidity and a regulatory crackdown on leveraged investment caused a rarely seen inversion of the yield curve."

An inversion in the yield curve suggests that credit is tight in China. When credit is tight, defaults will increase and over leveraged companies will close down. Further, the longer the yield curve is inverted, the more severe the downturn. Since the inversion just started, it is too early to say that China will be in trouble. However, one should start monitoring it and reconsider whether to invest in China and Hong Kong shares if the inversion continues for next 3 months.

Tree notes that recently since the last week of March, the Hang Seng Small Cap Index had started to underperform the Hang Seng Index. This also suggests that speculative capital is flowing into Hong Kong large cap stocks only, causing a sharp rise in the Hang Seng Index. This may not be sustainable due to the rich valuation of some of Hong Kong's large cap stocks.

Hyperion suggests that given the strong run up in SG equities for the last 9 months since SGD weaken versus USD, it may be a good time to divest. A good strategy maybe to buy the Vanguard Total International ETF on NASDAQ which has a well diversified portfolio of 6000+ large cap stocks in the world excluding US. This is to protect against any economic shocks. Normally one would go into bonds when uncertainty is high. However, due to the possibility of rising interest rates for the next 3 years, investing in bonds would likely be unprofitable. The next best alternative is to go for a portfolio of well diversified dividend paying REITs or dividend paying large caps in this scenario. Further, given the strong run up of US stocks, most US stocks are likely trading above fair value now. In contrast, the valuation of large cap companies outside of US are on the low end relative to the US companies. Thus, odds are in favor of the investor who chooses the cheaper alternative.

Tree highlights that if interest rates increase in US and other countries decides to match the rate increase for FX stability, small cap stocks worldwide will likely suffer because small caps have less access to credit. As a result, stock pickers would likely have difficulty beating the index which mainly contains large cap stocks.

What do you guys think?

Hyperion and Tree

[postage paid]

From what I understand, this is a manufactured tightening by the PBOC rather than one that is triggered by the market, hence I believe it is still within the PBOC's control at this stage and if it does spiral out of control, then the PBOC will be there to slow the spiral.

Regarding valuations, HK and China equity valuations are cheaper than in most markets and it is a sign to be invested there on a relative basis. It is hard to predict the future (foresight) but we can at least see where we are now (eyesight). The speculative capital that you talk about may not be that speculative after all since Xi Jinping is visiting 1 July and there are rumours the Chinese government is standing ready in all aspects to project a good image towards that day. This could be the market pricing that in as only the large cap stocks have enough liquidity for traders to position themselves. I'm actually more interested in the HK small cap index now that it has underperformed, either there will be some spillover effect or it could remain rather unaffected once the July trade unwinds. In the meantime, valuations remain undemanding as well.

I agree that its time to lower exposure to SG equities. Valuations are high relative to economic fundamentals. We must remember that we make money when things turn out better than whats priced by the market and I dont see how that can be possible right now in the SG or US markets. I think there may be some opportunities in the O&G sector in SG as it is still negative and could get worse if there is a risk aversion spillover from Noble Group. With the US I think oil majors are a good sector to rotate into as they are trading at reasonable valuations and generate good cash flows other O&G companies are also worth a close look as M&A activity is likely especially since cash is still cheap and there are some strong balance sheets out there (e.g. Exxon) who have not really moved (Shell moved too early).

I would not touch bonds and REITs at this stage as I think the risk to reward ration there is not attractive. Prefer to stay in Fixed Deposits and wait and see what happens. It is extremely rare for the markets to be so calm (i.e. low VIX) when the underlying environment is so uncertain. Ultimately prices must reflect fundamentals.

I think unless there is a severe credit crunch, it is the large cap liquid stocks that will fall more as they are the ones that have attracted the "tourist investor" dollars who are just here for good time and follow the momentum. Small cap stocks tend to be family owned and I think access to funds is generally not a problem for them as long as they did not over leverage on cheap credit.

I actually think stock pickers will have a great time especially with the ETF wave growing.

[weijian]

Searched the DB and it seems like we don't really talk much about yield curves inversion here. Probably nest this analysis here on the recent yield curve inversion.

Is there a signal in the noise? Yield Curves, Economic Growth and Stock Prices!

The yield curve is a simple device, plotting yields across bonds with different maturities for a given issuing entity. US treasuries, historically viewed as close to default free, provide the cleanest measure of the yield curve,  and the graph below compares the US treasury yield curve at the start of every year from 2009 to 2018, i.e., the post-crisis years:

The yield curve has been upward sloping, with yields on longer term maturities higher than yields on short term maturities, every year, but it has flattened out the last two years. On December 4, 2018, the yields on treasuries of different maturities were as follows:

The market freak out is in the highlighted portion, with 5-year rates being lower (by 0.01-0.02%) than 2-year or 3-year rates, creating an inverted portion of the yield curve.

http://aswathdamodaran.blogspot.com/2018...urves.html

[karlmarx]

Various authors have touted different variables as indicators of economic and/or capital market recession. These variables, which are mainly a measurement of one or more aspect of the marco-economic environment, are not always easily understood. In the case that one does, reliance on any one of these variables will lead to parochial perspectives, and hence, an inaccurate assessment of the situation. Possibly, a selection of such variables thought to be the accurate indicators could be assembled to provide a more complete picture. I believe this is done by economists, and some of the global-macro/quantitative-AI hedge funds.

In principle, there are similarities between assessment of a business, and assessment of an economy. As there are indicators to a business' health, so it is with the economy's health as well. In both cases, these indicators are laboriously pored over, from which a conclusion is reached.

But would the investor who focuses solely on the analysis of the business' merits -- vis-a-vis its price -- be disadvantaged without the incorporation of various economic indicators in his analysis? Or would such investor perform better because there is less to distract him?

Certainly, it will be delightful to know when the economy/market will be down. But such endeavours -- concerning model building and running simulations -- are far beyond my abilities; the intimate acquaintance of which is also not something which I expect to enjoy. While I remain undecided on the efficacy of following such variables -- and then relying on it -- in the making of investment decision, I am inclined towards staying close to what has proven to work for myself.

[specuvestor]

We cannot predict with certainty where a molecule will move in a Brownian motion within a container, but we can measure the result: Pressure. When say temperature changes, the pressure changes in GENERAL but there might be a lag even between the bottom and top of the container

So is it with the economy vs businesses. We can look at businesses (energy of molecules) to estimate the economy, or vice versa but it is not a 1-1 correlation. People still live in a deterministic world and dont realise known unknowns and unknown unknowns are very real but risks that we choose to take carefully.