When thinking about the implications of a flat-to-inverse yield curve for an economy, you don't need a doctorate in applied mathematics or economics to understand that it's not supportive of properly functioning capital markets. Investors prefer to receive more return alongside the greater risk they take. If a bondholder is effectively lending money to a business for a long period of time, they would like to earn more return. This is because the longer the timeframe an investor commits their capital, the more return they would naturally demand. Over shorter periods, an investor would not require as much return since there's an opportunity to reinvest more rapidly returned proceeds elsewhere (e.g., lower opportunity cost on an ongoing basis). Shorter time periods also represent less uncertainty for expected return of capital, generally speaking.
As the accompanying chart illustrates (referencing the yield spread between the 2- and 10-Year U.S. Treasury bonds since 2004), we haven't experienced such severe and protracted yield curve inversions since just before the Great Financial Crisis ('08-'09). The yield curve inversion occurring lately is unmanageable, albeit slowly improving from more than a 100 basis point inversion seen just a short while ago. For an economy to maintain significantly higher short-term interest rates relative to significantly lower long-term rates, capital markets participants would be collectively confounded by the choice to assume more risk while expecting less return. This is wholly illogical and breaks one of the cardinal rules of investing - taking greater risk means expecting more return. Prolonged periods of inversion beget irrational beliefs on how capital markets are supposed to work, and even what the core values of capitalism are about.
Based on our research (which guides the capital allocation decisions within the ACGM Total Portfolio Solutions Suite™), we see little incentive to take on both duration and credit risk. Instead, regarding our bond allocations, we continue to favor shorter-term fixed income securities, as well as FDIC-insured CD's and money markets. Additionally, equity markets are in an adjustment period to this new higher interest rate paradigm. Therefore, we continue to be significantly underweight U.S. and Non-U.S. stock markets by a full 1000 basis points below neutral target weightings for each portfolio solution strategy. A possible credit event could finally spur on broader market awareness to the underlying vulnerabilities. Such an event, associated with both corporate and government's bond maturity wall, would thereby force comprises, technical defaults, and even bankruptcies for specific corporate issuers. Likewise, government fiscal policy would be more greatly constrained to combat future crises.