Yield curve inversion has been the tool of choice for predicting a recession in 2019, but for an investor, the real question is what will happen to risky markets. At the extreme, who cares whether you can predict a recession, an investor wants to know what will happen to their equity portfolio. Fama and French have published a simple working paper on the impact of inversion on equity risk premium called, "Inverted Yield Curves and Expected Stock Returns".
Fama and French conclude that inverted curves do not predict low stock returns using a global database includes decades of inversions. They test the impact of inversion through a simple process of switching from a passive equity portfolio to a blended equity and cash portfolio based on prior time spent with negative term spreads. If negative term spreads (inversion) tells us nothing about the equity premium, then switching to a blended (active) portfolio will underperform the passive portfolio.
The message is counterintuitive but clear. It does not matter what an inversion may be telling investors about recession, you don't want to bet against the equity premium. I would like to see more details concerning specific cases, but the unambiguous results using a simple test are compelling and will require deeper study to refute.
Fama and French conclude that inverted curves do not predict low stock returns using a global database includes decades of inversions. They test the impact of inversion through a simple process of switching from a passive equity portfolio to a blended equity and cash portfolio based on prior time spent with negative term spreads. If negative term spreads (inversion) tells us nothing about the equity premium, then switching to a blended (active) portfolio will underperform the passive portfolio.
The message is counterintuitive but clear. It does not matter what an inversion may be telling investors about recession, you don't want to bet against the equity premium. I would like to see more details concerning specific cases, but the unambiguous results using a simple test are compelling and will require deeper study to refute.
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