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The Inverted Yield Curve And The Family Office

Joe Freeman, September 12, 2019

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"This time is different" - an expression that often carries undertones of hubris. Does the inverted yield curve in bonds mean we are headed for a downturn?

It is often remarked that when yields on short-dated government debt are higher than those with durations of 30 years, for example, that this is a red flag for a potential recession. Whether this holds in all or most cases is keenly debated. Right now, the US Treasury yield curve is inverted, and so alarms are sounding. What should family offices and other ultra-high net worth investors think about this? To discuss the topic is Joe Freeman, head of family office services at Abbot Downing, part of Wells Fargo. The editors are pleased to share these insights and invite responses. This news service does not, of course, always agree with views of contributors. To add to the debate, feel free to email tom.burroughes@wealthbriefing.com or jackie.bennion@clearviewpublishing.com

What should a family office be doing as a result of the inverted yield curve? Historically, when the yield curve inverts significantly for more than a few weeks, it is a reliable indicator of a recession in the next year or two. The precipitous drop of the long-end of the yield curve in August resulted in the 10-year treasury yield dropping below the two-year. According to the Wells Fargo Economics Group, this has occurred prior to the past seven recessions. Is this foreboding the end of the expansion and suggesting that family offices begin to prepare for a recession?

I acknowledge that many believe “it is different this time.” The collapse of the term premium due to the Federal Reserve’s balance sheet, negative convexity, buying due to hedging, foreign purchases and the lack of inflation have all been discussed as reasons to discount the slope of the curve’s predictive prowess. However, the current economic cycle in the United States is the longest on record, growth is slowing, geo-political tensions are mounting, and trade-induced angst is taking hold of investments.

There’s sufficient evidence to warrant consideration of action
Family office investment portfolios are widely considered “patient capital”. Families often measure success in decades rather than calendar quarters. This portends that pre-recession adjustments may be slight, but the overall impact could be material given the size of the portfolios managed. The actions below are designed to protect investments on the downside, participate in the upside, and increase engagement of the family.

I believe now is the time to visit our mission statements, investment objectives and policy statements. Do these continue to accurately reflect the family’s goals? Is your current investment allocation appropriately aligned with the above? If you determine that your portfolio bares more risk than your policy dictates, it’s far better to realign allocations at the top of the market than the bottom.

Next, we often make tactical shifts around our strategic targets. If you haven’t already done so, there are sufficient warning signs to suggest shifting tactical weights toward a neutral or even slightly defensive posture. Precedence would suggest many more months of growth and risk appetite but slowly increasing yield exposures, counter cyclicals and cash is appropriate in the face of increasing volatility.

An impending downturn is a great opportunity to also consider spending policy. This far into an economic recovery and bull market, it is not uncommon for generous practices to materialize around distributions. From houses and cars to vacations and entertainment, distributions are plentiful when markets are surging. If you don’t have a formal distribution/spending policy, now is a good time to create one or make sure you are within guidelines. Significant purchases, new investments, ongoing financial obligations and general spend rate should be given additional consideration at this time.

Warren Buffett once said that as an investor, it is wise to be “Fearful when others are greedy and greedy when others are fearful.” Having plenty of cash on hand from defensive posturing as well as reduced spending and investment positions the family office well to get greedy when revaluations naturally occur at the end of the cycle. In addition, banks often tighten credit during contractions; so, now is the time to negotiate credit facilities to take advantage of lower rates and create “dry powder” to use when others are forced to sell.

With your portfolio allocation confirmed, tactical weights aligned, spending curtailed and dry powder ready to go, it’s time to think about family members. Are there steps that each member of the family should be considering outside of the family office portfolio? The inverted yield curve is a great excuse to have a conversation. Such learning moments are important for every generation, but especially the generations who may be too young to have gained useful experience from the Great Recession.

The concept of the curve inversion may be too esoteric for many
A discussion of economic cycles, inflation, growth, and what to expect over the next few years will serve as a foundation when this historic recovery finally ends. While there’s unlikely a need for the family branches to make significant alterations to their standards of living, discussing the environment and sharing what the family office is doing to exercise prudence can go a long way to improve engagement.

Finally, beware of investor psychology gone awry. Large moves made on intuition, personal insight or “gut feelings” rarely end well. Families should question their family offices prudently to make sure decisions are based on facts and figures and founded on basic investment principals. The best strategies and tactics will be backed by analysis, logic and precedent.

Family offices are long-term investors. Significant portions of the portfolio are tied up in direct investments, real estate, low-cost holdings and operating companies; however, just about every family office has a liquid portfolio and distributes income to family. The yield curve inversion is a warning sign of slower growth and potential trouble ahead. Now is not the time to be greedy; it’s the time to review your policies, prepare your portfolio, and educate the family. It’s rarely “different this time.”




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