While our risk-off stance and higher volatility calls won us some bragging rights through 2018, during our forecast meetings with clients in Q4 we laid out three conditions that, were they all to be met, would cause us to become outright positive on risk assets. Collectively, we referred to these as the ‘trampoline’.
First, the Fathom Leading Indicator (FLI) should remain positive and show signs of accelerating growth. The negative impact of US-Sino trade tensions and China’s economic slowdown should progressively taper off, and investors should come around to our view that concerns about a trade war are not sufficient to tip the world into recession. Second, US equity markets needed clearly to underperform other developed and emerging equity markets, as value came to the fore. Third, either credit spreads needed to widen or market liquidity, as measured by the Fathom Liquidity Indicator (FLiq), needed to rebound.
There has been some progress with regard to the first two conditions set out above. Our leading indicator (FLI) remains weak, but it has at least stabilised, reflecting an easing of concerns over the trade war following a resumption in US-Sino negotiations, as well as additional policy stimulus in China and continued strong employment data in the US. In addition, equity markets have broadly kept pace with their US counterpart, which should be seen as progress given their sizeable underperformance in 2018.
On the other hand, the widening of credit spreads and the underperformance of credit indices in December, now partly reversed, was simply not material enough in our view, particularly at a time when regulators were drawing attention to potential difficulties in that sector. This muted market response is particularly noteworthy when compared to 2015 and is surprising given some more prominent structural developments.
For example, investors redeemed a record $85.9 trillion from high yield funds in December according to the Investment Company Institute, while issuance fell off a cliff with only $0.6 million new bonds issued in the US high yield market. That is against a backdrop of a record $13 trillion total corporate debt outstanding. Also, as much as 19% of investment grade bonds and 11% of high yield bonds are due to mature over the course of the next two years, in an environment where tightening liquidity, as highlighted by our FLiq, may only get a temporary breather from the Fed.
Overall, we feel that the market has been too dismissive, and has failed to look in the right places. As we highlighted in a recent note on the evolution of leverage ratios among US firm, we are concerned about the rapid deterioration in the health of so called ‘good companies’, not the health of the always risky high yield or leverage loan markets.
In an environment perhaps eerily similar to that of today, debt-to-equity among lowly-geared firms peaked in 1999, a year before the market meltdown. Today, as in the late 1990s, investor complacency remains rife. Bluntly, we fear the current environment is planting the seeds for the emergence of another Enron or Worldcom, which could have ripple effects well beyond credit markets, just as it did in 2001. One measure pointing to complacency is the evolution of the ratio of the VIX to high-yield spreads. Last year, concern among equity investors rose significantly in comparison to high-yield spreads. In the past, this phenomenon has been a precursor to large systemic shocks, such as the dot.com meltdown, the global financial crisis of 2008-09, and the Greek default of 2011.
The bottom line is that unless we see corporate spreads rise to match the levels of concern expressed by equity investors, or unless liquidity improves significantly, then the prospects of a ‘dead cat bounce’ appear greater than those of a more sustainable rally in risk assets. As a result, we maintain our more cautious stance for now. This matches the findings of our fixed-income allocation model, the full results of which were released to clients last week. Currently, it unequivocally favours a more defensive stance, given faltering expectations for growth and tight liquidity conditions.
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