Are investor portfolios structured to withstand a market correction?

With the recent, global move to coordinated central bank easing, the industry has been talking about whether we’re creating a financial bubble.

On Aug. 12, CNN published an article with the headline, “Central bank rate cuts are inflating a cheap money bubble,” while Bloomberg published an article with a similar headline on April 3: “Fed risks stoking financial bubble in drive to lift inflation.”

Add to this the recent inversion of the U.S. yield curve — the two-year bond yield was marginally higher than the 10-year bond yield — and investors are wondering what it all means.

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Until recently, the U.S. Federal Reserve was on a tightening bias, increasing the federal fund’s rate — the rate at which banks lend to each other. With the most recent rate cut, that stance has shifted to monetary easing in a bid to increase inflation to the desired level. The European Central Bank is said to be embarking on a fresh round of monetary easing given slowing economic activity, in part due to the continuing trade wars between the U.S. and just about everyone and in part due to slowing global growth.

When determining whether we’re in an asset bubble and what the implications might be, pundits look to a number of factors.

One measure is the yield curve, with recent focus on the inversion between the two-year and 10-year rate. An inverted yield curve has often been cited as a precursor to an economic recession and has been a pretty reliable predictor since 1956. The yield curve inverted in 2005 and a profound recession began in December 2007, followed by the global financial crisis of 2008. The yield curve also inverted before the technology bubble burst in 2001.

However, a brief yield curve inversion may not result in a recession, at least not immediately. History suggests recessions follow inverted yield curves by an average of 22 months, which takes us to June 2021. Stock markets continue to do well for 18 months following a yield curve inversion, which is February 2021, based on the same analysis. Another report suggests the S&P 500 composite index tends to rally for another 7.3 months on average post yield curve inversion, which would take us to February 2020.

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There’s some talk the yield curve has inverted of late as the market is telling the Fed that short rates are too high and more easing is required. As well, some believe the yield curve is distorted by more than $15 trillion of foreign bonds presently paying negative interest.

Odd fact, a Danish bank is paying its borrowers 0.5 per cent per year to take out a mortgage. Many European banks have more cash than lending ability as nervous investors wait out the current market gyrations, expecting some sort of market correction.

Canadian bond markets have benefited from investors hungry for yield, finding our 10-year bond yield of 1.5 per cent juicy compared to what’s available in other bond markets. Non-resident investors purchased $12.9 billion of Canadian bonds in May 2019, reversing a trend for the first four months of 2019, where investors shifted to equities.

Another measure being monitored is overall stock market capitalization versus gross domestic product. The technology stock market bubble in 2001 was presaged by a ratio of 146 per cent (market cap versus gross domestic product), which was then followed by burst bubbles and bear equity markets. This ratio hit 137 per cent in 2007, though this time it was a housing bubble. More recently, this ratio hit 147 per cent in October 2018, which resulted in a 20 per cent equity market correction.

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While this measure is interesting, a key difference between 2001, 2007 and today is the level of interest rates, which are much lower today than they were then. This begs the question whether higher ratios may be supported in the current environment.

Forecasting isn’t an exact science and statistics can be manufactured and shaped to fit our various theses. However, what is clear is that we’re closer to the end of the economic and market cycle than the beginning and investors need to consider whether their portfolios are structured to withstand the next market correction, whenever that might be.