Four links in the global financial market chain have weakened: which is next?
This week’s column is indebted to two charts from Fidelity’s vastly experienced fund manager Ian Spreadbury at a recent conference. This is not to put words into Mr Spreadbury’s mouth – he needs no help on that front – and any views expressed here are strictly those of this column, but credit must be given where credit is due.
The first chart shows the yield on the benchmark 10-year US Treasury (US government bond) which could be seen as a decisive break-out above the 3.05% level.
There are three possible explanations for this apparent shift in bond market momentum:
Fixed-income investors are still wary of the potential for inflation to surprise to the upside, especially as oil prices march higher.
An annual US budget deficit that is expected to reach $804bn in the year to September 2018 and $981bn to September 2019, compared to $665bn in 2017. The US Government has to sell more bonds to fill the gap and greater supply means it may have to offer a higher coupon to tempt buyers.
The US Federal Reserve’s switch from quantitative easing (QE) to quantitative tightening (QT). The Fed will reduce QE by $30bn a month this quarter, $40bn a month from July and $50bn a month from September. The end of QE removes a huge buyer from the bond market just when supply is going up.
Where US 10-year yields end up remain to be seen. Yet it may not be a coincidence that certain riskier and more speculative areas of the financial markets appear to be coming under duress just as the returns from a purportedly safe asset (and one priced in the globe’s reserve currency for good measure) start to look more tempting.
FOUR QUICK HITS
In quick succession, bitcoin, low-volatility trading strategies, high-flying technology stocks and now emerging markets (and especially emerging market currencies) have at least stumbled or in some cases been routed.
The sudden reversals in the Turkish lira, Indonesian rupiah, Mexican peso and Argentine peso all suggest investors are, slowly, starting to become more risk averse, especially after their experiences with bitcoin and trading the VIX index and an initial wobble in tech.
Any chain is only as strong as its weakest link. Whether this is a warning of further trouble to come in more mainstream assets, such as UK and US stocks, remains an open question. Yet no-one could have imagined that a downturn in Florida’s housing market and the collapse of two obscure hedge funds in 2007 would be the first stages of a two-year financial panic and bear market in share prices.
None of this mean indices like the S&P 500 and FTSE 100 are destined to plunge soon but the combination of low volatility, lofty valuations (especially in the US), and rising interest rates (at least in the US) is a potentially tricky one.
The good news is that earnings forecasts are still being met or exceeded, so estimates are rising.
Real, near-term trouble for equity investors could come in the form of a global economic slowdown – or even an actual downturn – as that would hit corporate profits.
That in turn would leave valuations looking too rich, based largely as they are on the assumption that record corporate profit margins will stay high or go higher, and also potentially expose dividends to cuts as companies see their earnings and cash flows start to diminish.
And this is where Mr. Spreadbury’s second chart comes in. It shows the US 10-year Treasury yield minus the Fed Funds rate.
On the three occasions when the Fed’s target rate has exceeded the 10-year Treasury yield since 1990, a US recession quickly followed, in 1990-91, 2001-02 and 2007-08.
This indicator also proved accurate with the double-dip downturn of 1979-1982 but the chart below does not go back that far.
This is not a prediction for 2018 and the good news is that the US 10-year yield of 3.11% still comfortably exceeds the 1.75% Fed target rate.
But if the Fed sticks to its script with two or three more increases this year then investors need to keep a very close eye on both the Fed and the US bond market as the year develops.