I Remember Nothing
When Lehman collapsed ten years ago, the US economy was already slowing and the Fed had started to ease. While some people worry about leverage in credit and high valuations in equities, it’s hard to see any kind of repeat of the great financial crisis. But that doesn’t mean there won’t be some problems down the line. The US expansion is long, the stock market is at record highs, monetary policy tightening has further to go and positive sentiment on the economy and earnings is having to deal with waves of negative sentiment coming from the world of politics. In 'bond-land', despite US yields having risen, the asset class remains quite expensive. It’s been difficult to get positive returns so far this year and there remains the distant possibility of a more pronounced bond bear market. The best hope is that inflation remains benign and default rates remain low so that bond investors can continue to eke out carry where they can find it with a minimum of downside risk. As people return from holiday that is going to be challenging.
Ten years ago, just a few weeks before the investment bank Lehman Brothers filed for Chapter 11 bankruptcy protection, then Federal Reserve Chairman, Ben Bernanke, delivered a speech at the Jackson Hole central bank conference entitled “Reducing Systemic Risk”. The introductory comments to his presentation (still available on the Federal Reserve website) paint a picture of a deteriorating economy amid dramatically tightening credit conditions. The narrative of the time reflected the collapse of the sub-prime mortgage market, the rescue of Bear Stearns and the looming collapse of UK lender Northern Rock. As we now know, Bernanke’s valiant attempt to suggest that governance and oversight of capital markets was being strengthened was too late to prevent the biggest financial collapse in modern history. Post-Lehman, credit spreads blew out, equities went into a bear market and the economy entered a deep recession.
There are some interesting macro observations from that period. The yield curve actually inverted in 2006. The US economy peaked in the final quarter of 2007, almost a year after the unemployment rate bottomed out at 4.5%. The S&P500 peaked, at a then record high, in October 2007 amazingly defying evidence that the economy was hitting some serious trouble and apparently ignoring the impact of a mortgage market that was in free-fall by the summer of 2007 with all the implications of that for consumer confidence and credit markets. House prices did not bottom until 2012, the economic contraction lasted until the first quarter of 2009 and unemployment continued to increase until the end of 2009. The global impact of the crash was tremendous. All G7 economies went into recession and it took a number of years for developed economies to get GDP back to the level it had been at the end of 2007. Italy has still not achieved that.
That period saw the worst financial crisis and deepest recession that most of us have ever seen and hopefully will never see the likes of again. It is an extreme benchmark against which to compare what might happen when the current expansion does eventually come to an end. This week the S&P500 index hit another record high and is closing in on a decade long bull market. That, together with the length of the US economic expansion, the steady (almost complete) flattening of the Treasury yield curve, the rolling over of growth in other parts of the world and the more volatile political environment leads many to conclude that the tenth anniversary of the recession that followed Lehman will be marked by the beginning of another recession. Indeed, just turn on Bloomberg TV and there is a debate over this very issue on a daily basis. The bears point to tightening monetary conditions as quantitative easing (QE) is rolled back along with the potential negative impact of increased trade protectionism. The bulls point to the economic data, the ongoing investment in technology and persistently strong earnings growth that is sustaining equity valuations. Current consensus forecasts for S&P500 earnings per share are for a growth of 22% over the next year and a 10% growth in dividends, and a re-run of 2008 is very unlikely. Bernanke talked about strengthening the infrastructure of financial markets in his appearance at Jackson Hole a decade ago and we all know that, in the wake of Lehman, the focus on public policy was on increased regulation and governance. Banks have more capital and all aspects of financial market activity are much more regulated today than was the case when, as the scene in “The Big Short” reminds us, providers and traders of structured credit products were partying hard in Las Vegas.
With my bond investor hat on I do worry about the left-hand side of the distribution of outcomes. There’s always something to worry about but in practice the question I ask myself is: what kind of returns should I expect from the bond market going forward? We still live in a low yield environment and from a pure carry point of view (the return that a bond investor gets from the coupon income), the market is not very exciting. Of course, this has been the case for some time and bond returns in 2018 reflect that. The best performing sector so far this year has been US high yield, with a whopping 1.2% of total return to the end of July. The worst has been emerging market hard currency debt which has delivered a negative 2.8% return over the same period. We would put those two sectors in the same risk category even though the drivers of return are very different. Historically the correlation of returns between US high yield and USD denominated emerging market debt is between 0.6 and 0.7, and they tend to perform in similar ways given that they are both ‘credit’ sectors with risk premiums above US treasuries as the key valuation metric. The correlation has broken down somewhat this year given that the performance of emerging market debt has been (as it does tend to be) more macro driven while high yield in the US has benefited from strong corporate earnings growth. Within emerging market debt there has been a wide dispersion of returns. Turkey has been in trouble most of the year and the total return on the Turkish external debt bond index is -9.9% for the year to-date. In contrast, the equivalent index for Russian hard currency debt is down just 0.8%. Indeed, Turkey displays the hallmarks of a typical emerging market crisis economy. It has a large current account deficit, a large pile of foreign currency denominated debt, a tendency for high inflation and a political system that has increasingly concentrated decision making in the hands of a strong ruler. While Erdogan may concede to market pressures to some extent to arrest the severity of the crisis, it is hard to see what catalyses a significant recovery in Turkey without some kind of debt relief or externally sponsored and funded adjustment programme. This may not sit well with the nationalistic approach of the current government but it may prove inevitable if Turkey is to avoid a significant drop in GDP over coming years.
Turkey is an extreme but it could be a canary in the coal mine relative to the potential impact of gradually tighter global liquidity conditions. The Fed has raised interest rates by 175bps since December 2015 and is expected to deliver another 50bps before the end of this year. It is also reducing the size of its balance sheet. The European Central Bank (ECB) has been quiet this summer but is on track to end its asset purchases. Japan has started to allow bond yields to trend a little higher. The Bank of England raised rates in August. Don’t get me wrong – global monetary conditions are not tight but they are tightening. So far it has been quite benign. Look at the US. Since August 2016, 10-year Treasury yields have risen by 150bps and a typical US Treasury index has delivered a total return of -3% since then. At the same time, US high yield has outperformed treasuries by 16% and the S&P500 has risen by 32%. It has been a reflationary period. Index-linked bonds have outperformed conventional government bonds as well. It could carry on like this until there are signs that the US economy is starting to crack. In the summer of 2008 the alarm bells were already ringing loudly, particularly around anything to do with housing. Today, the US consumer is buzzing, corporates are confident, after tax income growth has been boosted and no-one wants to be left behind in the race to digitalise their businesses. The Fed may have discussed some of the downside risks at the last FOMC meeting but, on balance, bulls are likely to remain in charge for a while to come.
It has been a relatively quiet summer in the markets, apart from Turkey and a mini-crash in Chinese high yield in July. There is likely to be more noise at least in coming months with lots of chatter about the Italian budget, the impact of the end of QE in Europe, China’s ability to deal with trade protectionism, and Brexit. Personally I don’t get the sense of any impending big moves in bonds in the short run. But who knows? There has apparently been a record high volume of short positions in the US 10-year Treasury futures contract with some investors clearly looking for an eventual break above the 3% level that has been resilient so far. The strength of the US economy, the likelihood of further hikes by the Fed and the gradual rise in inflation are strong reasons why yields should be higher – it’s just that those reasons have been in place for ages and the market has stayed quite strong. Where else could there be moves? US high yield spreads are back close to their lows, as is the VIX equity volatility index. This is consistent with the record high in the S&P and all round bullishness on corporate America. But one could envisage an event-driven short squeeze in treasuries and a sell-off in risk. The divergence between high yield and emerging market debt performance may also see some reversal should sentiment improve towards emerging markets, perhaps on the back of some more conciliatory moves on trade. Again, who knows? I am merely speculating on what could move fixed income markets going forward. Apart from the example of 2015 when the US high yield sector was hit by downgrades to the energy sector, the pattern has tended to be that high yield and emerging market debt trade together, emerging market debt sells off, high yield holds in and then emerging market debt recovers. I suspect that the current episode will follow a similar path.
Fixed income has been expensive for some time. Government bond indices have more duration than ever for some of the lowest yields ever. Spreads and yields are close to their lows. The share of BBB-rated securities in high grade credit indices has risen steadily since the crisis yet spreads are close to their lowest levels. Arguably, across the fixed income spectrum investors are not fully compensated for the fundamentals risks (inflation, rates increases and credit deterioration/default). But it has been this way for ages, supported by the central bank put which is only slowly being taken away. Over time, valuations will adjust, especially if the global expansion does deliver higher inflation (fact check – US CPI inflation at 2.9% is now at its highest level since 2011 and definitely in the higher 50% of the range of inflation outcomes since 1990) or, alternatively, a slowdown raises credit risks. There will continue to be that distant dark cloud of a more pronounced bond bear market.
Only a game
Talking of dark clouds, reports suggest that all is not well at the Theatre of Dreams (Old Trafford, home of Manchester United). Concerns have been raised about the third season syndrome that appears to have afflicted Jose Mourinho’s managerial career. It is suggested that the manager and the star player, World Cup winner Paul Pogba, are not getting on. It’s probably exaggerated but United fans are uncomfortable with the style of play, the results so far (admittedly after only two games) and the fact that the self-congratulatory outfit across the city is scoring goals for fun. Mourinho leaving a club under a cloud is as predictable as a peripheral sovereign credit review and unless the mood improves, the season does not hold out much hope for the Reds. If they can’t get something from a tough match with Spurs on Monday the hysteria will get more intense. Perhaps, for my own sanity, given my son’s imminent departure to study in Los Angeles, I should just become a Galaxy fan. Go Ibrah!