Yield Curve Inversions

As the yield curve continues to flatten, there has been increased focus on the potential for "inversion" which means that short-term rates are higher than long-term rates. Central bankers have begun mentioning it, we have seen an increase in media mentions, and we have even received a few questions from clients. Below is a chart of the difference between the 10-year US Treasury yield and the 2-year US Treasury yield. The 10-year yield is usually higher than the 2-year yield, but short-term rates surpass long-term rates every now and then. Historically, these inversions have occurred prior to recessions (as indicated by red vertical bars).

USGG10YR Index (US Generic Govt  2018-07-17 15-28-07.png

A few observations:

  • The yield curve may very well invert, but has not inverted yet. The curve almost inverted in 1994, but did not and the next recession was not until 2001.
  • The recessions charted above have began 12-24 months after the curve first inverted, while it was nearly 3 years after the 1998 inversion.
  • With rates at historically low levels, there are good reasons to doubt that a flat or inverted yield curve is as predictive as in the past. We have our opinions, but it always pays to see multiple sides of an issue and no indicator should ever been overly relied upon or used in isolation.

The above being said, we do not think that the yield curve is indicating an imminent recession. Of course, the shape of the yield curve does have implications for risk/return dynamics and portfolio positioning and investors should adjust accordingly.

Introducing MFA Impact Strategies

MFA has focused on impact investing for a number of years now, but to date has only made very targeted investments in areas like low-income housing finance and microfinance. We have avoided broader allocations to impact investments, as many of the publicly-offered mutual funds and exchange-traded funds (ETFs) were either poorly constructed, expensive, or required other unattractive trade-offs.

However, investor interest has been building for years and seems to have finally reached a tipping point recently. We are now seeing an explosion of new products, as well as fee reductions on existing products. Consequently, for the first time, investors are now able to construct an impact portfolio of global equities with publicly-offered funds that are both low cost AND closely track the major benchmark indices.

Nearly all impact strategies screen out objectionable products and industries (such as tobacco or cluster munitions) and incorporate non-financial considerations into their shareholder voting, but we recognize that different clients prioritize values differently. We are happy to announce that we will be offering two main strategies:

  • A broad-based ESG strategy that tilts towards companies with superior Environmental, Social, and Governance (ESG) practices.
  • An environmentally-sustainable strategy that focuses primarily on environmental factors, such as greenhouse gas emissions, fossil fuel reserves, and other sustainability considerations from land use to water management.

We will be publishing more information in the coming months, but feel free to reach out if you are interested or would like to learn more.

A Primer on Divestment [UPDATED]

Like many Americans, I've been saddened and angered by the increasing number of mass shootings in our country. My wife and daughters even braved the rain and hit the streets to March For Our Lives a couple weekends ago. As the activism against assault weapons increases, so are calls to divest from assault weapon manufacturers and distributors. Thus, I believe now is as good a time as any to talk about "divestment."

Definition: Divestment is the act of excluding a company, industry, or sector from an investment portfolio.

Reasons to Divest

  • Many (including myself) practice divestment as a way to align their portfolios with their values. Some investors would rather not receive any investment benefit from the sale of assault weapons (or cluster bombs, chemical weapons, and so on) and so choose not to own companies associated with these products.
  • There is also an argument that investing in risky or controversial businesses is risky because risks and/or controversy invites activism which can result in stricter regulations. Just ask tobacco companies or oil drillers.

However, investors should also understand what divestment will not do.

Reasons Not To Divest

  • Divestment reduces the supply of capital available to a company which increases its cost of capital. However, there are still plenty of investors willing to invest. So although divestment increases a firm's cost of doing business, it also increases the returns to that firm's investors. Cliff Asness of AQR recently summarized this concept in an aptly-titled piece: Virtue Is Its Own Reward: Or, One Mans Ceiling Is Another Man's Floor.
  • Readers may point out that a higher cost of capital and weaker financials should result in weaker share prices and performance. Perhaps in theory, but I have not found the weight of empirical evidence compelling.¹
  • Divestment campaigns have not been shown to be effective historically, except to the extent that they are a means for social and/or political stigmatism. William MacAskill (a leader in the "effective altruism" movement) asks and answers the question: Does Divestment Work?
  • Not only is divestment unlikely to hurt a firm's shareprice or investors, it is unlikely to benefit those who divest. Excluding a miniscule industry like firearms manufacturers will make no discernable difference to capitalization-weighted investor. Excluding larger industries or sectors may result in increased tracking error versus a benchmark, but is unlikely to make a material difference over a multi-decade timeframe as most sectors mean revert to the market over time.² I've found most arguments otherwise are timeframe dependant (ie. just changing the starting and ending dates results in different outcomes).
  • The upshot is that if divestment will not make a major difference to an investor's portfolio, then investors can also capture market rate risk and returns without many (if any) tradeoffs.
  • Investors that own funds may find it expensive to divest if they have unrealized capital gains. Rather than divest and pay tax on the capital gains, it would arguably be more effective to donate an equivalent amount to an activism campaign.

Other Options
Divestment is one of many tools that investors can utilize to align their portfolio with their values and/or effect change. Other options include:

  • Underweighting or otherwise optimize their exposure to objectionable companies, industries, and sectors. Kind of a "divestment-lite" approach.
  • Maintaining exposure to an industry or sector, but only invest with the most responsible or "best in class" firms (perhaps those that are pivoting away from the objectionable business).
  • Maintaining ownership of shares in order to engage with management through voting proxies and/or bringing shareholder resolutions. Sometimes having a seat at the table is the most effective way to effect change.
  • Invest in companies that counteract the problem or solutions.

Divestment can be a great tool to align portfolios and it is something that I personally practice. Like anything else though, investors should consider their goals and objectives to ensure that divestment is the right approach for them.

Footnotes:
¹https://www.ussif.org/performance
²http://www.nepc.com/insights/fossil-fuel-divestment-considerations-for-institutional-portfolios & https://www.mayorsinnovation.org/images/uploads/pdf/FINAL_Revised_NorthStar-Cost_of_Divestment.pdf