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Moving Away from Reality …. Again
11th February 2019
Gary Dugan
By Falco Group
Investment Committee
  • Remarkable rebound in risk assets since the start of the year
  • The Federal Reserve’s ongoing support through QE at odds with its mandate
  • The Fed continues to hide the reality of modest long-term prospects for the economy
  • Emerging markets possibly the safest way of remaining in risk assets
  • Government bonds see good support
  • US government closure likely averted by President Trump accepting a smaller wall

There was always room for a rebound. However, the year-to-date performance of risk markets such as corporate bonds and equities has been quite remarkable. Last week may have seen a pause in their performance, but the scale of money flowing back into these risk assets bodes well for markets at least maintaining their elevated levels for the moment.

The global equity index is up 8.0% year-to-date, US corporate high yield bond index has returned 5.25%. Lipper report that corporate investment-grade funds saw inflows of $2.7bn in the last weeks with high-yield (junk) bonds receiving their largest inflow since July 2016. High yield bond spreads that were 537bps at the recent peak are down to 400bps.

There was room for a rebound, but the Federal Reserve has taken the financial markets back to Wonderland again. We would urge investors not to get suckered into believing these are normal market conditions, far from it. The central banks have created a monster in quantitative easing (QE) and don’t know how to control it. The Fed has decided to keep the beast alive because they fear what will happen if they downgrade its power by reducing QE. However, leaving QE in place only continues to encourage poor behaviours on the part borrowers (particularly the US government) who borrow too much and investors who take inappropriate risks.

To give some context to how wrong current fed policy is, it’s worth reading a section from the speech of John C Williams, President and CEO, Federal Reserve Bank of San Francisco made on October 3, 2013: -

“when the federal funds rate was at zero and were at zero, and we were facing still a severe recession it was the right call to turn to asset purchases. However, once the federal funds rate is back to a more normal level, we should relegate asset purchases to a backup role, employing it only when conventional policy and forward guidance fall short.”

The quote reminds us that the Federal Reserve created QE for exceptional stress conditions in the US economy. A current unemployment rate of 4.0% and GDP growth of between 3-4% in the last two quarters reported does not smack of a crisis. Fed policy has morphed from the prudent to the abject prop of a casino financial market.

What should be more worrying to investors is that the Fed seems so worried about withdrawing QE. Could it be that QE is the only thing keeping the US economy from collapsing? The answer we hope is no, but the reality is that the Fed probably fears the impact on investors and corporates behaviour when they come to see that trend global growth has materially fallen in the past decade for structural reasons – ageing and slowing productivity growth.

If investors feel forced into the markets at these elevated levels emerging assets are the preferred asset mainly because at least you can argue you are buying long term value and not just a play on easy money conditions.

Emerging markets are justifiably up 7.3% year to date as they had markedly underperformed in 2018. A Fed that isn’t minded to tightening monetary policy and hence taking the winds out of the dollar is a kind Fed for the EM bloc. Emerging market debt has done well across the board with even riskier dollar credits in Russia and Turkey rallying since the start of the year.

Emerging market debt in aggregate has continued to perform well. The Bloomberg Barclays EM dollar debt index has given a total return of 3.3% year-to-date. Emerging market debt spread over government bonds has narrowed by 55bps since the start of the year.

The robust performance of high-quality debt (+1% year-to-date) shows that investors have split their new investment across the spectrum of risk. The safer highly rated investments have managed to eke out a positive return with the benchmark US government bond yield falling 5bps since the start of the year to 2.63%.

Near-term geopolitical risk factors could ultimately weigh on the markets. Brexit, US government shutdown and trade wars have not gone away. Also, not to be forgotten is the fact that quietly in the background analysts’ expectations for corporate profits growth have been declining. Analysts’ expectations for first quarter US corporate earnings have declined by 5.4% since the start of the year.

The geopolitical challenges will be in the headlines on February 15th when temporary funding for a quarter of the US federal government ends. There is a growing consensus that a deal will be found this coming week. It appears that Congressional Republicans have no appetite for a fight over the budget and hence President Trump is likely to acquiesce to a much lower level of funding for his Mexican wall than he was looking for. The assumption is that he will receive around $2bn against the $5.7bn sought. The nonpartisan Congressional Budget Office (CBO) estimates economic losses of the government closedown of $3bn in the fourth quarter of 2018 and $8billion in the first quarter of 2019. While the economy will recover some of its losses in subsequent months, the CBO estimates permanent losses of $3bn.