How a yield curve inversion affects stocks, and what to buy

If
the yield curve inverts, expect the bears to come out to
play.
Reuters

• The yield
  curve is at its flattest level in over 10
  years. 
• Its inversion has foreshadowed every US recession since
  the 1960s. 
• The Hong Kong-based trading firm CLSA has identified a
  dividend strategy that outperforms whenever the yield curve
  inverts. 

There’s no recession indicator more talked about right now than a
yield curve inversion.

Wall Street has been captivated as the curve, which plots the
difference between long and short-term bond yields, has slid to
its lowest levels since the financial crisis.

Notably, the difference between 2- and 10-year yields fell last
week to as low as 24 basis points, an 11-year trough. The gap has
turned negative before every recession since the 1960s.

If the curve’s flattening continues and
Morgan Stanley’s forecasts are right, the yield curve will
invert next year, meaning short-term interest rates rise above
long-term rates.
Economists aren’t in agreement that it would signal a
recession this time. Still, an inversion would gather “a big bear
party,” according to CLSA, a
top trading firm based in Hong Kong. 

As the bears come out to play, CLSA has a simple recommendation
for investors looking to profit if and when the curve inverts:
buy global bond proxies.

“A curve flattening/inversion cycle bodes well for high-yield
strategies, benefitting bond proxies the most at the expense of
GARY (growth at reasonable yield),” the firm wrote in a recent
note. 

“Indeed, in line with our preference for defensive growth, bond
proxies delivered strong performance in 2Q18 and could remain in
favor against a backdrop of rising macro volatility and growth
slowdown.”

CLSA

A yield-curve inversion on its own doesn’t cause recessions. But
it signals downturns because it shows the Federal Reserve is
raising interest rates too aggressively, lifting short-term
yields above long-term ones. 

CLSA finds that bond proxies, stocks with bond-like yields, have
outperformed during inversions. To screen for the best companies,
their criteria included stocks with dividend yields of at least
3%, and positive free-cash-flow conversion on average of the past
five years. Stocks in telecoms, utilities, and pharma led the
list. 

In the US, companies included Wisconsin
Energy, AT&T, Johnson
& Johnson, Pfizer,
Coca-Cola,
and Hershey.