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Market Commentary

With markets calm, the risks aren’t in the headlines

By August 20, 2018April 26th, 2024No Comments

Earlier in the year was “The February wobble”, barely a blip but it triggered all sorts of media hysteria.  Since then markets have mostly recovered, and in the last few weeks drifted sideways – a calm not reflected in the headlines.

But this calm might also be complacency as to the risks.

It feels late in the day for this cycle, which has been rolling for 9 years. One neat piece of evidence for this is that the pivotal US market is being driven upwards by an increasingly narrow number of stocks. A healthy market enjoys the participation of a wide number of companies in uptrends – the opposite is an unhealthy sign, as leadership for the uptrend is too narrow.

For example, 78% of the NASDAQ returns this year have been driven by just 3 stocks – Amazon, Netflix, and Microsoft. The same stocks accounted for 71% of the more broadly based S&P 500 index.  This is not new news – and it is getting more extreme, and this sort of polarisation doesn’t tend to end well.

More important still is the issue of debt. I know when you are primarily invested into stock markets there is an inclination to ignore the action in bond markets – you mustn’t, just as you should not have done in 2008. Significantly, if bonds and debt were THE main problem in 2008, which brought the world tumbling down, this problem is now greater on a number of indicators.

The authorities take the Nelson approach – “I see no debt problems” – which we covered off on page 16 of the latest TopFunds Guide. (Do email if you haven’t yet had your copy).

“There are two ways to conquer and enslave nations. 

One is by the sword. The other is by debt.”

-John Adams

The bond market doesn’t get nearly as much attention as it should.  Yet the global bond market is towards twice as big as global stock markets, and the daily trading volume is more than 3x greater in bond markets.  When the bond market goes POP! we all know about it

Most of us typically think of bonds as being lower risk.  Yet the reality is that this is where the greatest risks are taken, and this has been so through history.  Bonds are a win or lose bet.  No shades of grey as with equities.  The volume and quality of debt or bonds shapes the wider investment and economic environment, as we discovered in 2008.

It is no secret that poor quality debt creates the fragility which triggers nasty crashes.  For the avoidance of doubt this was made absolutely clear in a 2016 study of 17 economies over 150 years… the highest levels of debt are aligned with the most spectacular crashes

If you didn’t know that before, it was a hard learnt lesson in 2008, when overwhelming debt brought the world to its knees. The volume of that debt is now somewhat greater than in 2008, and the quality is somewhat lower

Different sources measure the increase in debt from 2007-2018 different ways. The analysts McKinsey believe that global debt, excluding financial debts, has risen 74% between 2007 and mid-2017.

While consumer debt was at the centre of the crisis in 2007/8 (e.g. mortgage debt), households are typically not driving the debt increases since 2008.  According to McKinsey 43% of the increase is accounted for by governments and 41% by non-financial corporate debt

Unlike companies, governments have lots of tools to manage their debts, even if we don’t always regard their use of these tools as sensible.

It is with individual companies and sectors where the first cracks are likely to appear. A number of old hands in the bond markets have made the point that it has never been easier to raise money. Equally it can be argued that the quality of the debt has never been poorer.

Two requirements of a nasty bubble…  Easy money and low quality.

In the recent TopFunds Guide we looked particularly at WeWork. It has a very clear business model which certainly meets a need, providing low-cost working space particularly for the so-called gig economy workers.  But digging into the detail reveals fundamental flaws in the business model and how it has been financed.

Other companies have taken advantage of the availability of cheap debt by selling the dream.  As Grant Williams says, it’s an ongoing laboratory experiment and it has enabled big-name companies to emerge from the wreckage of 2008 and to sell the dream to investors…

…Uber, AirBnB, Snapchat and Tesla.

Companies like these raise money in the high yield bond markets, also called the junk bond markets.  Typically this is lower quality debt sold by companies who are less likely to repay their debts.  The size of that market in the US and Europe is now more than 70% bigger than it was in 2008.

At least the companies we’ve mentioned are (or  probably are) raising this money to invest in their businesses.  The same cannot be said for many others, who have been using corporate bonds to finance share buybacks.  We covered this issue a couple of years ago in the TopFunds Guide and in blogs at the time.

This is how share buybacks increase the earnings per share (EPS):

Before: 100 shares/£100 profits = £1 EPS

After:      50 shares/£100 profits = £2 EPS

Note that the total earnings or profits of the business didn’t increase, only the earnings per individual share in issue.

Guess what?

The remuneration packages of many of the executives who make these decisions have the potential for huge bonuses based on an increase in their earnings per share. Go figure.

This makes the gap between “the 1%” and the rest even greater than it already was.  As I have highlighted previously this wealth gap is not a new phenomenon – it didn’t arrive with Donald Trump, it didn’t suddenly happen after 2008, it has been going on for many years, decades.  Here is a chart showing how as the economy (represented by GDP) got bigger and bigger, the reward for ordinary folk got less and less:

Hence the electoral results which have plagued “the establishment”, the old world order, whatever you wish to call it, across Europe and in the US.  Having ignored politics for decades, investors now have to keep a weather eye on political issues.  Political risk, in the indebted Western world in particular, is here for a decade or two yet, and that will likely drive extreme moves in markets.

I digress, back to bonds.  To summarise:

  • We know global debt is somewhat greater now than in 2007/8.
  • We know the volume of low quality debt (junk bonds) is a lot higher.
  • We know the issuing of these junk bonds has supported business models which will not survive the next downturn.
  • We know the availability of cheap debt has encouraged many executives to line their pockets.
  • We know that zero interest rates have encouraged “yield seeking” behaviour.

Or as John Mauldin put it, where “yield” refers to income or interest:

“The insanity of yield-hungry investors throwing cash at borrowers while demanding little in return.”

This links to the liquidity issue.  The ability to buy and sell bonds (otherwise known as liquidity) has always been a significant risk, but it is worse than ever, yet seldom discussed.

There is no online system for buying and selling individual bonds, with known and guaranteed prices, as there is for equities or shares.  For the majority of individual corporate bonds there is no regular dealing.  Up to 2008 the investment banks largely acted as a “middle man”, providing prices for bonds.  These dealers were where you went if you wanted to sell or if you wanted to buy.

As long as there were both buyers and sellers the system worked.

But chaos ensued when no one wanted to buy at any price in Autumn 2008.  High yield or junk bonds fell 70-80% in value, and even investment grade bonds fell 30-40%.  And in many cases even these prices were just theoretical.

Investment banks largely withdrew from this market after 2008, reducing their role by about 80%.  That is bad enough but the size of the US bond market has since doubled (to $5.3 TRILLION).

The participants have also changed dramatically.  A market which was dominated by institutions now has retail investors heavily involved.  A decade ago corporate bond ETFs were no greater than $20 billion.  Today that number is $300 billion.

15x greater!

2008 was a huge shock to some professional bond fund managers – the corporate bond market seemed to collapse overnight – someone pressed the “off” button – they were not prepared.  And these were the pros.

Now we have a brand new class of investors in this market who expect daily liquidity – they expect to be able to sell their funds at all times, every day.  There is a huge shock coming their way.

When panic begins to build, and it will, many bond investors will not be able to sell what they want to sell.  So they will sell what they can sell – for example, their stock market holdings, whether individual shares, ETFs or active funds.

There are already early signs that all is not well – just as occurred in 2007.  In July 2007 the collapse of two Bear Stearns funds, seemingly out of the blue, raised liquidity issues which eventually morphed into the global crisis of Autumn 2008.

In recent days GAM has taken the decision to liquidate nine bond funds, sell everything and return the money to investors.  This came after they suspended trading in the funds days earlier, stopping investors selling, after a flood of investors tried to remove their money.

The fund manager (responsible for £8.5 BILLION) was also suspended at the end of July. These were “unconstrained” and “absolute return” bond funds – basically the sorts of funds where the managers have few constraints, and can venture into particularly esoteric and less liquid parts of the inherently illiquid bond market.

This is precisely what happens when illiquidity raises its ugly head.

It is early days, but for the bond market the tide has started to go out.  And those with no swimming trunks on are already beginning to be exposed.

Needless to say we are keeping very close to markets, and are happy that most clients have a healthy chunk of their portfolio in cash – there will be fantastic buying opportunities.

Dennehy Wealth