With the usual caveat that these are possibilities, not forecasts, and none might come to pass, the bank notes that “they are all things that could spring a surprise. They vary in terms of their probability and the size of their likely economic and market impact, both globally and regionally. Most risks are negative but we include some positive ones as well.”
The bank breaks risks down into three categories:
- Eurozone crisis 2.0
- Trade tensions end
- Brace for (climate) impact
- US corporate margins fall
- EM reform surprises
- The ECB initiates new unconventional policies
Liquidity & volatility risks
- Leverage risks and accounting tactics
- The Fed keeps hiking
- No bid in a credit sell-off
- Fixed income volatility comes back
The Top 10 risks are summarized in the following table. We suggest using a magnifying glass:
And here are the details:
1. Eurozone crisis 2.0
- A downside surprise to the economy is a key risk, particularly as there will be leadership changes in key EU institutions
- In this scenario, given a renewed focus on credit, HSBC would be cautious on Sovereigns with weaker fundamentals and EUR IG credit in general
- Bunds usually win in this situation but given valuations, flight-to-quality flows may head to US Treasuries
2019 rising risk, depleted ammunition
If stimulus is needed, the eurozone may have a problem …
The eurozone economy remains vulnerable. After an unusually strong expansion in 2017, economic growth is slowing back to trend and core inflation remains subdued. It will be hard to agree the necessary reforms due to the growing popularity of more populist parties. The ECB is out of sync with the US Fed and could potentially face a global slowdown with negative interest rates and so little by way of monetary stimulus to offer. At the same time, countries with fiscal headroom are unlikely to use it. Therefore the eurozone economy, which has a relatively high reliance on trade, is at the mercy of the global trade cycle.
… in a year of (possibly disruptive) leadership changes
All this comes at a time of significant change in Europe’s leadership. Four of the EU’s top positions (at the Commission, Council, Parliament and the ECB) are set to change hands in 2019. Meanwhile the domestic political environment in individual countries means that the heads of government in Germany, Italy, Spain and the UK could conceivably change next year as well.
What if populism overcomes Europeanism?
The political landscape has evolved since the last time the eurozone faced an existential crisis, because populist parties have gained more support across the continent. So far tensions have been around immigration rules and budget deficits, but we wonder what would happen if differences between Brussels and member states escalated dramatically. Europe’s recent history suggests it requires an extreme situation to take hold before decisive action is taken. Shaky economic foundations and political uncertainty would not be a healthy backdrop for European debt markets especially if the future of the euro was once again called into question.
The EUR would get close to parity with the USD
The first eurozone crisis prompted EUR weakness, but the political will was there to sustain the project and avoid a break-up. When the ECB’s President Mario Draghi promised to do “whatever it takes” to preserve the EUR, he could be confident of the political support. However, as we’ve seen in the run up to the French presidential election, when the political support is undermined, a more pronounced reappraisal of the currency is likely and the EUR could potentially reach parity against the USD.
The risk-off environment would favor the USD, JPY and CHF. A particular complication would be for GBP given the UK would likely be in the middle of negotiations with the EU about its future trade relationship. The EU has been able to provide a united front so far where protection of the integrity of the EU and the single market were the key shared objectives. Were this challenged by a more EU-sceptic political make-up, GBP would face even greater uncertainty.
Another eurozone crisis would present a challenge for weaker credits…
As we have seen in the past, a marked ‘flight-to-quality’, resulting in outperformance of German Bunds is likely. In a repeat of the past both Agencies and supranationals could underperform as Schatz and Bobl spread could widen.
Markets would likely question whether there is enough firepower or willingness in the eurozone to provide financial support to a bigger country or countries (in terms of GDP) than during the previous sovereign debt crisis.
For Bunds there would be, however, a major valuation challenge. Ten-year Bunds now yield less than 30bp and are close to recent lows having averaged 50bp in the last year. More importantly, Bund yields were 2.0% only five years ago and 3.0% before the last big crisis in 2012. In a ‘flight-to-quality’ the US Treasury market would be likely to attract renewed interest from overseas investors, particularly given yields are close to 3.0%.
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2. Trade tensions end
- The post-G20 truce in China-US trade tensions initially gave some relief to the market, as negotiations got underway
- But the outcome of the trade tensions remains uncertain, and trade prospects are further clouded by WTO disputes and Brexit
- An end of trade tensions could boost investors’ sentiment and have a positive impact on China and EM assets
Taking trade to the brink and back
Rising trade risks
After a strong trade recovery in 2017, goods trade growth levelled off in 2018. Tough trade policy actions by the US targeted China specifically, but also affected partners around the world such as Canada, the EU and Turkey, among others. In Europe, the Brexit process added to the trade uncertainty.
Trade policymakers have delivered a few recent breakthroughs and a few more may be pending that could help to revive trade prospects. October 2018 witnessed the ratification of the Comprehensive and Progressive Agreement for Trans-Pacific Partnership, a deeply liberalising accord among 11 Pacific Basin nations with a combined GDP of USD10trn. The EU and Japan are advancing in the ratification of their bilateral trade deal, which will remove most duties, increase agricultural market openness, and tackle challenging non-tariff barriers (e.g., regulation) in areas like autos and pharmaceutical products. Neither of these trade deals includes China or the United States. And, facing commercial pressures, businesses engaged in trade in the US and China intensified their advocacy for market-friendly reforms to address the mutual grievances between these two nations. The US and China could make a move in 2019
Trade policy developments in the rest of the world and mounting costs could encourage the US and China to build on the initial progress arising from the positive bilateral meeting of Presidents Trump and Xi on 1 December 2018 following the G20 meeting in Buenos Aires. It is possible that by early 2019, they could agree on measures to improve respect for intellectual property and limit trade-distorting state support for businesses. Under such a scenario, their mutual punitive tariffs could be removed.
Trade policy bliss
These positive steps would be reinforced during 2019 if the US were to agree to re-join the CPTPP. This could set the Pacific Basin region on course to potentially boost trade by 10% and GDP by 1% (PIIE, 2017). In the face of such a move, China and 15 other Asian-Pacific nations might finally conclude the Regional Comprehensive Economic Partnership, which would reduce tariffs and facilitate investment across the region. That would contribute gains to regional GDP of roughly 0.4%, according to PIIE. Progress in the Belt and Road Initiative could further contribute to the easing of impediments to trade. As a consequence of these and other actions, trade growth might revive in what could be a sustained manner.
Growth expectations and “risk-on” would impact FX
In our view, there would be two channels through which an end to recent trade tensions would impact FX markets. The first would be the direct trade linkages. The second would be a likely pick-up in global growth expectations and a subsequent “risk-on” sentiment.
First and foremost, the RMB would likely retrace some of the depreciation seen in 2018, although it does still face a slowing domestic economy. Elsewhere, the likes of the AUD, NZD, TWD, KRW, CLP, PEN and BRL would likely outperform as they sit within the group of “risk-on” currencies. Currencies in other, small open economies such as CEE3, SGD and THB might also benefit due to their general trade openness, despite being less directly linked to the US and China. The USD, JPY, CHF and to a lesser degree the EUR, would all likely face downward pressure as safe havens. MXN and CAD have already benefitted from the signing of USMCA agreement so would be less likely to benefit.
Positive impact on EM equities
If concern about US trade policy abated, EM equities broadly would benefit; within EM, China, Korea and Taiwan could benefit disproportionately. Commodity countries exporting more to Europe and China than to the US have been relatively unimpeded (Russia and Brazil). Korea and Taiwan, both manufacturing producers with a US focus, have been hurt more meaningfully.
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3. Brace for (climate) impact
- Extreme climate events are becoming more costly and more visible
- Damage costs are impacting DM regions, not just EM
- Risk of adverse market reaction to climate events in 2019
The frequency and severity of extreme weather events did not relent in 2018. Europe saw unseasonable cold spells and summer heat waves; floods hit Japan, India, Australia and China; destructive typhoons wreaked havoc across SE Asia and wildfires raged across California, Greece and Sweden.
Besides physical damage and longer-term social effects, these episodes represent growing climate risks across economies, businesses and society – all with investment implications:
- Cape Town continued to suffer from prolonged drought in early 2018, weighing on economic growth prospects (Running dry in Cape Town, 8 February 2018). Cape Town’s drought posed risks to growth and net exports in the region. Tourism was impacted and agricultural productivity dropped.
- Floods in Kerala, India in 2018 displaced 1m people (3% of the state population), causing an estimated USD2.85bn in asset impairments and damaged one third (70,000km) of Kerala’s total roadways. This highlights the importance for development to be “climate proof” (Kerala floods highlight vulnerability of development, 24 August 2018).
Climate change can be described as “a change in average weather”. Whilst individual weather events are not caused directly by climate change, the chances of more extreme events occurring in any given year are higher (region and type specific) and the severity of these can be magnified by climate change.
Negative impacts can be profound, including the loss of life, infrastructure damage, supply chain disruption and productivity slowdowns. Financial implications for companies and governments can be large. Agricultural commodity markets can be disrupted as weather events affect yields and harvests, and bonds and equities hit by climate events can see downgrades and declines. We believe these risks and their associated costs (Chart 1) may not be fully priced in by investors.
As climate change damage costs become evident, and governments try to limit it without imposing heavy costs on their citizens, a wide range of securities could be impacted. Preparing for climate impacts requires investment. The US utility Southern California Edison estimated that making its equipment more fire resistant will cost USD670m over three years. San Diego Gas and Electric spent more than USD1bn over 10 years to fireproof its equipment.
But full preparedness is expensive and elusive. The Pacific Gas & Electric Company (PG&E) has spent USD15bn in the last five years to upgrade its equipment and make it more fire-safe yet it booked a USD2.5bn charge related to wildfire claims in the second quarter of 2018. PG&E’s share price fell by 45% after the autumn 2018 Camp Fire in Northern California, which burnt through 154,000 acres and destroyed 14,000 homes.
Indeed PG&E (Baa3Rfd/BBB-Cwn) saw its credit ratings cut three notches by Moody’s and S&P, due to its role in the 2017 and 2018 California wildfires. It also saw a sharp sell-off in its bonds (Chart 2). Elsewhere, we think there is a clear link between a Sovereign’s CDS level and climate change resilience (Chart 3) (Sovereigns and ESG, 10 Sept 2018). If more focus is given by the market to extreme events in 2019, we could see further spread widening as a result.
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4. US corporate margins fall
- US profit margins are at an all-time high and forecast to move up…
- …but cost pressures are rising
- Faster than expected wage growth could cause a significant miss to earnings estimates and derail the equity bull market
The major driver of US earnings could reverse
We expect earnings to be the key driver of equities next year. Tax reform provided a significant boost to US earnings this year, with EPS currently estimated to have grown 23% (or c.14% adjusted for the tax reform). This was timely, as equity valuations were beginning to look quite stretched, and earnings growth has been a key support for the market in the face of tighter US monetary policy and higher Treasury yields. But the focus has turned to the outlook for 2019, with slower forecast GDP growth and a marked earnings slowdown, with consensus forecasting 9% growth.
One of the biggest risks to profits comes from margins. Margin expansion has been a key component of higher US earnings, accounting for c.60% of 2018 and 50% of 2019 expected EPS growth. We have argued that a significant negative US earnings surprise would globalise. A 70bp decline in net profit margins would see US index EPS fall in 2019, assuming sales grow in line with consensus expectations. This would probably be enough to see US, and global, equities decline.
US profit margins are at a record high of 11.7% and companies are facing growing cost pressures. Concerns of lower US profit margins have been around for some time but have failed to materialise. Indeed, there are structural reasons why profitability may remain elevated – the reduction of the corporate tax rate to 21%, the growth of tech, and a related increase in industry concentration in the US. But we are now beginning to see a confluence of rising cost pressures which, if corporates are unable to pass onto consumers, could finally bring profit margins down
Wage growth is perhaps the biggest risk. Wages are equal to 12% of US company revenues. So far growth has been subdued. But with the unemployment rate near a 15-year low, the risks are arguably skewed to the upside. Indeed our analysis of corporate conference calls shows over 70% of the discussions on wages indicated upward pressures. Our estimates of sensitivity to wages indicates that a 1ppt rise in wages would take off 1.5ppt of earnings for the MSCI USA, mainly Food Retailing, Transport and Autos.
Borrowing costs are also increasing with the US Fed continuing to tighten monetary policy, and a backdrop of US corporate leverage that has increased significantly in recent years. Whilst maturities have also been extended, short-term debt is relatively low, and cash levels robust; this could however prove a growing headwind as companies have to refinance over the next couple of years.
The end of the US equity bull market
A meaningful decline in profit margins – perhaps driven by an acceleration in wage growth – could be enough to derail forecast US profits growth, and hence the US bull market – especially if resurgent wages saw the Fed driven to tighten monetary policy further. Were net profit margins to fall back to their 10-year average of 9%, US EPS would fall by almost 20%. With US equities accounting for over half of global equities, this would have significant impact.
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5. EM reform surprises
- We remain broadly cautious on EM going into 2019…
- …given the tightening in financial conditions and enduring trade conflicts
- But what if EMs start focusing on structural reforms to address their imbalances, boost productivity, and improve efficiency?
The outlook for emerging markets has darkened throughout this year. This reflects a sharp tightening in financial conditions (charts 1 and 2), with many large EM central banks forced to re-couple with the Fed by raising their policy rates either to support their currencies or to prevent capital outflows, in an environment of declining global liquidity and rising funding costs. Moreover, escalation of trade protectionism and its potential impact on global supply chains has further complicated the EM outlook, despite the latest truce following the recent G20 meetings. So we think emerging markets stand on shaky foundations, which is likely to remain the case going into 2019. As such, we are broadly cautious and selective on EM from a top-down perspective (GEMs Investor: Shaky foundations, 7 Oct 2018). But what if external or internal factors were to make EM shine again?
The potential external drivers for a better EM performance are obvious in our view: these include a dovish Fed and a benign US/G3 rate outlook, the end of the USD bull-run, the end of trade tensions, some of which are discussed separately in this report. The domestic drivers, on the other hand, are not equally obvious as EMs are so different from each other. Yet, one common theme could be that EMs surprisingly rekindle their reform stories to help address imbalances, boost productivity and improve efficiency.
Could the crowded election cycle pave the way for reforms?
2018 saw elections in Russia, Turkey, Mexico and Brazil, though 2019 will be even busier, with nearly half (13) of the 30 countries under our coverage holding elections, ranging from presidential, parliamentary to local elections.
Among the larger EMs, markets will closely follow elections in Turkey, Indonesia, India, South Africa, Argentina and Poland, in chronological order. Anecdotally, structural reforms become more pressing when there is economic hardship and/or pressure from financial markets. Similarly, sweeping reforms could arguably be better timed right after the elections in order to capitalise on fresh mandates. This is sometimes referred to as the ‘first 100-day impact’.
In terms of potential reforms, markets could be positively surprised if we see progress on:
- Argentina: Fiscal reforms were in line with the IMF programme
- Brazil: Social security and fiscal reforms to rein in the budget deficit and public debt, privatisation efforts
- India: Continued fiscal reforms and overhaul of the banking system
- Indonesia: Continued fiscal reforms and infrastructure investments
- Mexico: Earlier energy reforms were implemented, prudent fiscal stance
- Russia: President Putin’s “May Decree” actually boosted potential growth
- South Africa: Labour market and education reform and reforming the parastatal companies
- Turkey: Labour market reforms, education reform, food supply management
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6. The ECB initiates new unconventional policies
- The ECB might enter the next downturn with negative rates…
- …so would need to look at restarting QE and, possibly, a range of other unconventional measures…
- …which could lead to a weaker EUR, lower bond yields and delay the credit sell-off
What if the European economy loses momentum?
Starting the next downturn with negative rates?
Eurozone growth is slowing (Chart 1), core inflation remains stuck around 1% and lower oil prices mean headline inflation is set to fall back sharply next year. We only expect a single ECB rate rise before the US rates cycle starts turning in 2020 (Chart 2). There is a high risk, therefore, that the ECB will face the unprecedented challenge of entering the next downturn with rates still below zero. With limited likely scope for fiscal action, the ECB might need to deploy an increasing array of stimulus options and initiate new unconventional policies.
An unappetising menu
We discussed these options in An unappetising menu: Options for the ECB in another downturn, 26 November 2018. They range from (limited) rate cuts, to more QE (which would require rule changes), to more ‘exotic’ measures including helicopter money, equity purchase and changing the inflation target. We think further rate cuts or QE can only be piecemeal, and that political and legal constraints, and financial stability risks, could impede measures that might have a larger economic impact. So the ECB might end up falling short – the next downturn might be prolonged and painful.
The single currency would likely weaken in anticipation of the announcement of a new round of easing measures, with the implementation itself not necessarily causing further weakness. We saw this in 2014 and 2015 when expectations around ECB easing were rising and EUR-USD fell from around 1.35 to around 1.05. One impediment to depreciation this time around is that the EUR is already somewhat cheap. Our long-term fair value metrics suggest equilibrium would be in the 1.20-1.32 range. A fall towards parity would be likely, but to move into significantly undervalued territory below there may also require an increase in structural or political pressure for the EUR. With EUR-CHF, EUR-SEK and EUR-CEE all facing downward pressure, the respective central banks may be forced to reconsider their own domestic policies at a time when they would all still have very low policy rates. The response might involve direct FX intervention or targeting of currency levels.
10-year Bund yield back to zero
Although the resumption of ECB QE would not increase the net purchases in German public sector purchases (PSPP) issues markedly (due to hard constraints), market expectations that reinvestments would remain for a prolonged period and renewed forward guidance on interest rates, should keep core yields low. The gloomy macro-economic outlook and benign inflation projections would likely bull flatten the eurozone core curves with the 10-year Bund yield potentially heading back towards the 0% level. Supranational bonds could play a more important role as substitute purchases (for German bonds).
Delay the EUR Credit sell off
Our analysis shows that idiosyncratic risks are temporarily suppressed by the announcement of measures such as the Outright Monetary Transactions (OMT) in 2012 and corporate bond purchases (CSPP) in 2016. A key risk to our bearish view on EUR Credit would be if the ECB restarted CSPP. EUR IG spreads could tighten, but in the context of deteriorating corporate earnings, this might just delay a market sell-off but wouldn’t reverse the credit cycle.
Negative impact for European equities
Under this scenario European equities would probably suffer. European earnings are already disappointing versus consensus expectations, and a more pronounced downturn in domestic growth would be likely to drive a significant miss. We would therefore expect further de-rating for the region ahead of any announcement. However, as with previous rounds of stimulus, we would expect the initial reaction to any announcement to be positive, particularly if the ECB moves towards equity purchases as our economists discuss. A weaker Euro would likely drive relative sector returns whilst lower bond yields should support longer duration sectors. An extension of non-standard monetary policy measures would shift the balance of power from lenders to borrowers and would be negative for European banks due to its impact on net interest margins and top-line growth.
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7. Leverage risks and accounting tactics
- US nonfinancial corporate debt is at its all-time high and average credit ratings of investment grade debt have fallen sharply
- Elevated leverage and risk of higher funding costs point to debt servicing and refinancing challenges ahead
- Some companies may resort to accounting tactics to meet expectations or covenants
Refinancing challenges ahead
After a period of balance sheet repair and replenishment in 2009-2013, US companies began to actively re-leverage their balance sheets from 2014 onward, tempted by historically low borrowing costs and the desire to capitalize on the gathering US economic recovery. Indeed, US corporate debt as a percentage of GDP is now at a record level, well above the previous peak in 2008.
A bigger concern, in our view, is the degraded credit profile of the USD IG nonfinancial corporate universe. According to our calculations, about 50% of the debt capitalization of the USD IG index carries a Bloomberg composite credit rating of BBB. Specifically, the debt market capitalization of the BBB category (i.e. BBB+/BBB/BBB-) of the USD IG corporate bond index is over 2x larger than the debt market capitalization of the entire USD HY cash bond index.
The US corporate sector currently has plenty of cash but net debt to EBITDA for the USD IG nonfinancial corporate universe increased in H1’18 to a 15-year high despite reporting double-digit percentage earnings growth over the same period.
If corporates were to be faced with the combined challenge of the increased cost of borrowing, and potentially lower operating profits in an economic downturn, then it is likely that some would struggle. The pressure to keep reported results to forecasts and balance sheets within covenant limits could increase the risk that some companies will be tempted to use accounting judgements and decisions to overstate their financial performance and position. For those who that do, the methods are varied and often specific to the circumstances, but include:
- Recognising revenue early, for example, by changing an accounting policy to recognise on shipment rather than delivery or, using an aggressive judgement to determine the level of completion on a long-term contract thereby increasing income.
- Deferring costs, for example, by capitalising items that should be recognised immediately in the income statement, or re-aging debtors to not recognise a provision for doubtful debts.
- Not recognising liabilities for example, taking an overly positive view of an outcome of a claim and therefore not providing for it.
- Changing assumptions, for example on fixed assets, if the useful life and residual value are increased then the annual depreciation charge can be reduced and the value of the assets on the balance sheet is maintained.
- Deferring large cash payments, for example payments into pension schemes.
- Reclassification of one-off items into/out of operating income and cash flows, into financing or “one-offs” when the item is negative and vice versa. This is particularly acute when companies provide investors and lenders with non-GAAP1 measures
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8. The Fed keeps hiking
- We expect three more Fed hikes until June 2019…
- …but there is a risk that core inflation could accelerate and the Phillips Curve steepen, leading to further hikes
- We think UST2y and US credit would be under pressure
Fed tightens beyond current expected levels
Fed policy changes in 2019 are likely to be more “data dependent”. We expect three more hikes in the current cycle: December 2018, March 2019, and June 2019. While lower than anticipated job growth and inflation could lead to fewer rate hikes than the FOMC’s current median projection of three 25bp rate increases, stronger growth and higher-than-projected inflation could lead to a faster pace of policy tightening than currently anticipated by financial markets.
Core inflation could accelerate in 2019
Core PCE inflation has already moved up from 1.5% in Q3 2017 to 2.0% in Q3 2018. Upward pressure on inflation is increasing as the labour market tightens. Over the same four-quarter period, the unemployment rate fell from 4.3% to 3.8%, putting it well below most estimates of the non-inflationary unemployment rate. If monthly job gains continue at the roughly 200,000 average of the past year, the unemployment rate will likely drop close to 3.2% by Q3 2019.
Phillips Curve steepens
While the US Phillips Curve has been “flat” in recent years, there is a risk that it could turn much steeper at current low levels of unemployment. In addition to labour market pressure, the possibility of higher tariffs on imported goods also raises the risk for higher inflation in 2019. Though planned tariff increases were postponed at the G20 summit in November, a tariff increase from 10% to 25% on USD200bn of imports from China is still possible in 2019 and tariffs on an additional USD267bn goods imported from China are also being contemplated.
If core inflation were to accelerate above 2.5% by the middle of 2019, the FOMC may feel compelled to raise the federal funds rate higher than the Committee’s current median 3.125% projection for the end of 2019.
A more aggressive Fed tightening path would likely see the USD higher The market already has a lower trajectory priced in for the US policy rate during 2019 than is embedded in the Fed’s dots projections. Were the Fed to deliver even more than the dots imply, then the boost to the USD could be sizeable. The US-centric nature of the catalysts for a more aggressive Fed (a steeper US Phillips Curve, higher tariffs on goods imported into the US) suggest the impact would be USD-centric as other central banks would likely not match the Fed’s hikes.
USD strength might be most acutely felt in sections of EM FX and higher beta G10 FX plays. Unexpectedly higher USD funding costs and a buoyant USD would resurrect the pressures evident during parts of 2018 in EM FX, although weaker currencies and higher interest rates might provide greater insulation this time around. The scale of reaction would also partly hinge on how much of the upside surprise in Fed tightening was prompted by higher US growth and inflation. Within G10, a more aggressive Fed would imply a more pronounced acceleration of the USD bull trend evident since May 2018, with likely gains concentrated against the EUR and high beta plays such as AUD, NZD and SEK.
US front end of the yield curve would shift up significantly
Long-term US rates would move to the upper end of their recent ranges on a faster hiking pace by the Fed. For 10-year yields, this is the 3.25% area. This view assumes that longer-term rate expectations remain well anchored. We see that as the likely outcome given our analysis of the risk of higher or lower medians for the FOMC’s dot plot, dealers’ and investors’ projected distributions of the Fed funds rate in 2020, and the historical stickiness of the 5Y5Y Treasury forward rate versus the expected peak rate.
Yields in the front end of the yield curve would shift up significantly, if the Fed hikes to 3.125% or more at the end of 2019. The Fed funds futures market projects a 2.72% rate (4 December). So, a higher 2019 funds rate and expectations of a higher peak funds rate would likely shift the two-year Treasury yield up by 40bp or more from its current 2.82% level.
USD Credit under pressure
If the Fed were to raise interest rates beyond our expectations, USD credit spreads would likely come under additional pressure. The associated tightening in financial market conditions would exacerbate the risks associated with the US corporate sector’s heavily leveraged balance sheet. They are already being stressed by rising borrowing costs and credit rating downgrades resulting from late cycle behaviours, including aggressive share buybacks, high dividend payouts and a surge in large-cap, debt-financed M&A, among others.
Given our expectations that US GDP and corporate earnings growth will moderate in 2019, it is likely that the US corporate sector’s financial flexibility will remain compromised, absent a concerted effort to reduce leverage.
US equities and defensives to outperform
The outlook for US equities would depend on the growth backdrop in this scenario. If higher inflation is driven by stronger growth then equities could rise given that valuations have already derated significantly. But if tightening is in response to tariff related inflationary pressures the impact on equities would be negative. Multiples would likely contract further in this environment, and this would not be offset by stronger earnings growth. Defensive sectors with strong balance sheets would in theory fare best.
A tough scenario for emerging markets which favours EXD
Under this scenario, the EMBI spread which has widened by 114 bps, to 425 bps since the start of the year would probably come under further strain. As EM central banks would probably have to mirror the Federal Reserve, thereby extending the tightening cycle, we could see EM External Debt outperforming Local Debt in 2019. This would lead to higher funding costs and investors would be likely to demand a higher risk premium, pushing the GBI-EM LCD yield back above the EMBI EXD yield. This would benefit investments where carry is available without taking duration risk.
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9. No bid in a credit sell-off
- Corporate bonds remain a structurally illiquid asset class
- In a sharp sell-off, there is a limit to how much investors could sell
- Mutual funds and Exchange Traded Funds (ETFs) which tend to have a high level of retail investors are of particular concern
What if there was a liquidity crisis?
In Credit Telegram: Eight questions about corporate bond liquidity (15 November 2018) we looked at weekly bond level volume data for corporate bonds. We saw that while corporate bond liquidity generally declines as the year progresses, with dips in April and August, a pick-up in October and November, and a sharp drop in December, the pattern from year to year has been remarkably stable (chart 1). And this despite the spread widening we have seen this year, and despite new pre-trade and post trade transparency requirements introduced by MiFID II/MiFIR on 3 January 2018.
1. EUR IG weekly bond volumes: Holding up, for now
But corporate bonds remain a structurally illiquid asset class. In particular:
- 10% of bonds account for just under half of traded volumes and 20% of bonds account for about two-thirds of volumes. This appears to be constant across time and markets
- Most corporate bonds don’t actually trade every week. In the first 44 weeks of 2018, only 13% of EUR IG bonds and 25% of EUR HY bonds traded at least once a week
- Liquidity is strongly skewed towards recent issues, with bonds issued less than a year ago accounting for 34% of volumes for EUR IG and 41% for EUR HY
In a sharp sell-off, it follows that there would be limit to how much investors could sell – and after all, there has to be a buyer for every bond sold. Of particular concern are mutual funds and Exchange Traded Funds (ETFs) which tend to have a high level of retail investors.
In Who owns what in 2018? (16 May 2018) we estimated that retail funds and ETFs make up some 24% of GBP credit assets, 10% of EUR credit assets and 16% of USD credit assets. Even if institutional money tends to be stickier, large outflows by retail could significantly move prices.
The concern is that, just as banks engage in maturity transformation, mutual funds and ETFs engage in liquidity transformation. This was evident, for example, in the collapse of Third Avenue’s Focused Credit Fund in December 2015, which with only 10% of the assets BB or B rated, was much more a distressed fund than a high yield fund and arguably should not have been offering daily liquidity against these assets.
Even if investors understand that they do not benefit from deposit insurance and are subject to floating net asset value (NAV), given that mutual funds offer daily liquidity there is an incentive to be first to redeem in a market downturn. And even if a fund holds a portion of liquid assets, as a fund sells liquid holdings, the portfolio gets more illiquid, subjecting the remaining investors to time subordination.
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10. Fixed income vol comes back
- Central Bank actions and the private sector’s yield enhancement strategies have kept interest rate vol subdued
- With global reserve flow shrinking, there is a risk the trend may change
- If this happens, vol is likely to pick up in other asset classes too
The great unwind
Interest rate volatility has remained subdued over the last several years. The risk we consider is a sustained increase in fixed income volatility.
Why has fixed income vol been so low?
There are two key factors behind this period of calm: (i) unconventional monetary policies by systemically important Central Banks and (ii) short-volatility positions in order to gain yield enhancement. Some of the key Central Banks’ actions which have had structural impact on interest rate vol include: short-term interest rates stuck at their lower bounds; enhanced forward guidance on the likely path of future policy rates; and provision of excess liquidity in the system. They all have contributed in a narrowing of the probability distributions around future interest rate paths.
Why might this go into reverse?
The Fed has already hiked its target range by 200bps from its lows and the ECB could also hike sometime in 2019. More importantly global reserve flows have seen a sharp decline recently (Chart 1, for more see Reversal, 31 August 2018) and they may even go into negative territory if the Fed continues its balance sheet tightening policy. The key question then is what could be the impact on interest rate vol if one of the key players of short vol position exits the market.
What is happening with fixed income vol now?
Global proxies of interest rate vol have started to increase but have not reached a level which constitutes widespread concern for a broad set of investors. The very nature of short vol positions is such that the trigger point of a potential vol increase is difficult to anticipate, ex ante, but the cascading impact could be far reaching as some investors found in early 2018 after VIX spiked to 35.
While long-dated interest rate vol has failed to match the moves in the short-dated equivalents (Chart 2), it is a risk worth considering whether a sustained period of bear steepening of yield curves might force some unwinding of short vol positions. Rate hikes from the Fed and the BoE have opened up probability distributions around short end rates and this has led to a slow but steady pick-up in short-dated vol (for more see Mispriced ECB risks, 26 April 2018). Our fear is if volatility spills over into longer yields it may have implications for other asset classes as low and stable long-end real rates have been a key factor for performance of risky assets.
Clearly, if this risk transpires there would be direct implications for fixed income markets: higher fixed income volatility is associated with a move up in yields. Less clear-cut is what the implications would be for other asset classes. FX markets are strongly linked to fixed income markets, so we would expect there to be an equivalent reaction for currencies. And, as we saw this year in the equity market sell-off, higher rates are a concern for many equity investors.
3. Vol wave keeps on rolling
Not all vols are equal
As a result, it seems likely that higher fixed income vols would spill over into other asset classes. This would intensify the volatility wave we have been tracking for a few months in Data Matters (Chart 3). An increase in equity vol would be associated with equities selling off. The correlation between bonds and equities would probably change sign. This is not only of interest to those investors who trade correlation products directly – a changing correlation between equities and bonds has significant implications for the asset allocation process. This might lead to an overall reduction of risk among multi-asset investors as the benefit of diversification dissipates.