Bear Market 2015?
Cam Hui | Nov 03, 2014 11:44PM ET
Despite my bullish stock market outlook (see my last post Business Insider ):
Right now, the market consensus is that the Fed will start to raise interest rates in mid-2015. But Fed tightening, by itself, will not cause equities to tank. That`s because the Fed is tightening in response to a rising growth and inflation outlook. Higher growth translate to higher earnings, which should push stock prices higher.
What if the source of a bear market comes from somewhere else? I recently came upon the Euromoney ):
RBS recently surveyed 65 investors, including asset managers, hedge funds, insurance companies, private banks and others mainly based in Europe and the UK. Of these, the overwhelming majority (84%) sees lack of liquidity as a potential systemic risk for credit markets. Most say it is likely to get worse and while they are trying to manage liquidity risk, there is little consensus on how to do so.Alberto Gallo, head of European macro credit research at RBS, argues: "Credit markets may have outgrown dealers’ capacity to trade risk. We have now nearly $7.7 trillion of credit in the US, versus $22 billion of inventories on trading desks, the lowest ratio in history.
"It is harder and more expensive to trade corporate bonds: liquidity is down roughly 70% since pre-crisis."
Bond market liquidity in both Treasuries and corporates have been a problem for institutional investors:
"The Fed data suggest that the volume of corporate bond inventory the sell-side holds is about a fifth of what it was before the crisis," Nick Robinson, head of trading, fixed income at Schroders, tells Euromoney. "And the US corporate bond market has approximately doubled in size in that time."There have been lots of initiatives to try to address that. Many new agency brokers emerged very quickly – and subsequently disappeared – after Lehman collapsed. More recently, several crossing networks have sprung up, but to succeed they need a critical mass of clients while the market remains fragmented."
Another investor tells Euromoney: "Banks have very little inventory or balance-sheet capacity. At the moment there is a kind of spurious agency model with a bit of balance sheet behind it and a lot of smoke and mirrors."
Today, the HY bond market is not just the playground of institutional investors, but retail and fast-money hedge fund investors through ETFs. So what happens when default rates start to tick up and everyone tries to squeeze out a much smaller exit?
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The worst-case scenario is that stresses from a HY induced risk-off sell-off cascades into a financial crisis in the banking system.
Today, junk bond market performance (via the iShares H/Y Corporate Bond ETF (ARCA:HYG)) has started to roll over against equivalent duration Treasuries (via the iShares Barclays 3-7 Year Treasury Bond ETF (ARCA:IEI)). Past episodes have led to stock market weakness, both in 2007 and 2011.
To be sure, the problem does not appear to be excessive today. Howard Marks isn't finding a high level of financial stress from rising defaults. He believes that the investment environment remains favorable for equity prices:
Speaking of the environment, since mid-2011, our investing mantra across Oaktree has been move forward but with caution. In the US, we see the economy getting stronger and asset prices getting higher although not generally in bubble territory. Economies elsewhere especially in Europe and certain emerging markets are weaker. We are respectful of the determination of central banks to stem economic weakness by keeping interest rates historically low and the appeal of riskier assets high.More than five years into recovery as we are now, one would typically expect to see a pickup in defaults and other signs of distress. But of course nothing about this cycle has been typical so it isn’t surprising that defaults and distress remain in short supply.
In short, the potential stresses in the HY market are something to keep an eye on. For now, I remain cautiously bullish on risky assets. The risks in the junk bond market are a 2015 problem.
Disclosure: Cam Hui is a portfolio manager at Qwest Investment Fund Management Ltd. ("Qwest"). This article is prepared by Mr. Hui as an outside business activity. As such, Qwest does not review or approve materials presented herein. The opinions and any recommendations expressed in this blog are those of the author and do not reflect the opinions or recommendations of Qwest.
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