Over the last few years, we’ve experienced what one could describe as a Goldilocks scenario, with fairly synchronised returns from most assets including individual national stock markets. In this ‘regime’ we see that most sectors move upwards and there isn’t much differentiation in terms of returns between different types of stocks. Now that we’re entering a new world of rising interest rates, one of the few things that we can say with some certainty is that this ‘regime’ is probably at death’s door and we’re entering into a new dynamic, a new “regime”. Put simply different financial assets – and different parts of a stock market – might move in different ways. Bhanu Baweja, Deputy Head of Macro Strategy at investment bank UBS has nicely summed up some of these divergent trends and indicators. He notes that “Stocks globally have weakened, but small caps are outperforming large caps. LIBOR-OIS is widening, as are IG spreads, but high yield credit has remained largely unscathed. The USD has failed to strengthen. EM stocks have outperformed, EM currencies are only modestly weaker, while EM fixed income is rallying hard.”
How might these varying trends resolve themselves? The optimists suggest that sooner rather than later we’ll reach the top of the current interest rate cycle and then as interest rate rises stop, we’ll probably head back into slightly more synchronised global markets. Their argument – one which I largely agree with – is that interest rates can’t go too much higher for one very simple reason…there’s too much debt swirling around the global system. One stat sums it all up very nicely – there has been a 45% increase in global indebtedness since 2008. Some $75tn (75,000,000,000,000) of new debt has been created and much of this might default if interest rates were to rise too sharply.
More pessimistic inclined observers think they might be seeing the first inklings of a slowdown, mostly focused on credit markets. In this blog, we’ve already observed that some analysts think they’ve seen the first signs of this ‘turn’ – last month we looked at early warning signs from investment bank Liberum.
Analysts at risk consulting firm CheckRisk think that these signals are quietly proliferating. They point to an increase in US Treasury issuance, a decline in Bank Credit and the fact that the cost of $ hedging is rising, all early-stage warning indicators. Their concern – “The message is that market risk is rising but NOT to levels of major concern BUT we are starting to see the impact of so-called liquidity flattening or the removal of dollar liquidity”.
Arguably the biggest risk though centres on those central banks trying to raise interest rates. The average recession requires at least 350bps of interest rate declines to offset the effect of the economic downturn. The current Fed Base Rate is 1.75% and so rates have to double from here to provide a margin of safety. For outfits such as CheckRisk this introduces the most dangerous dynamic – Central Bank Policy Error. Namely central banks tightening their balance sheets too quickly, sparking a recession. Over at CheckRisk their Early Warning Risk System (EWRS) is picking up, especially in the USA. It observes that currently the risk spike is more centred on the LIBOR-OIS which may be indicating that banks are becoming more risk-averse.
What should the rest of us watch out for? Most analysts are concerned about the mispricing of credit risk i.e that lenders are underestimating the possibility of a sharp increase in defaults following interest rate rises. According to Check Risk “the liquidity in bond markets is not sufficient to support that kind of price discovery. Examples of credit mispricing may be seen in the UK, Canadian and Chinese housing markets, and more importantly in the Government Bond market”.