Investors worried about the direction that markets will take during 2020 have plenty of warning signs to watch for, say Man GLG managers, including another inversion of the yield curve, CCC bonds starting to underperform and indications that the US central bank is “losing control”.
Ben Funnell and Teun Draaisma, who run the Man Dynamic Allocation fund, have a broadly positive view of the year ahead but said there are three main risks that have the potential to emerge.
“Markets climbed a wall of worry last year and, despite our ongoing pro-risk view and positioning, being cautious types we need to keep watching out for what can now go wrong,” they said.
“We have not changed our base case of rising markets, but in recognition of higher expectations – and therefore larger tail risks – we have increased the size of our tail hedges, as there are threats out there worthy of our attention.”
Below, the managers highlight their three main worries for 2020 as well as the warning signs that they could be coming true.
Performance of fund vs sector since launch
Source: FE Analytics
US recession
The US economy is the largest in the world and, while it has been one of the strongest over the post-crisis period, investors worry about when its expansion will eventually turn into a contraction.
While US president Donald Trump has a powerful incentive to keep economic growth going given 2020 is an election year, Funnell and Draaisma said there are some signs that investors need to keep a close eye on for warning of a looming recession.
“Our Cycle Tracker, which we publish monthly, has six items in it: inflation, profit margins, Fed funds, yield curve, credit spreads and weekly claims,” they said.
“Of these, credit needs watching. Corporate profit margins are also becoming a concern as in the past corporates have tended to take action when margins have fallen to such levels, either deferring capital spending or laying off workers.”
Factors to watch out for to determine if the US economy looks like it’s on the brink of a recession include purchasing managers’ indices (which show if broad sectors of the economy are expanding or contracting) going below 50 points or the yield curve inverting once more. The Federal Reserve tightening through lifting interest rates or shrinking excess reserve balances could also come before a recession.
Credit cycle deteriorating
Any worsening in the credit cycle (which is the expansion and contraction of access to credit over time) would also be considered a negative event by the market. Some economists regard the credit cycle as the main driver of the business cycle, so any deterioration could warn of more challenging conditions ahead.
The Man Dynamic Allocation fund managers said: “There has been notable underperformance by the lower end of the junk bond market, with CCC-rated US corporate total return indices losing 7 per cent since the end of April.
“Meanwhile higher-quality credits in the BBB to BB and B ratings have continued to make 5 to 7 per cent returns. However, with CCC yields back up 275 basis points from 8.6 per cent to 11.4 per cent, they are now halfway back to the wides recorded during the oil shock in late 2015.
“While that episode was largely confined to the oil sector as the oil price halved, this time spreads are widening out as oil is going up.”
Investors who want a heads up of any deteriorating in the credit cycle should look out for weakness creeping into benchmark composition, CCC-rated bonds starting to underperform BBB and rising credit card delinquencies or poor headline figures around other loans.
Tightening dollar liquidity
Funnell and Draaisma’s final risk for 2020 is liquidity problems in the US undermine the Federal Reserve and challenge its ability to keep in control of bank funding costs.
They pointed out that the ‘corridor system’ – which constrains the effective Fed funds rate to a 25 basis point range between the upper and lower bounds – was broken in late September 2019.
“Fed funds swapped hands at 3 per cent briefly on 17 and 18 September, when the channel was 2-2.25 per cent, and the secured overnight financing rate spiked to 5.25 per cent,” they explained.
“Some people started to worry that the Fed had lost control. Our own view was more benign - that as long as the Fed is willing to use repo operations to inject liquidity and to add reserves into the depository system, it can retain control of bank funding costs.”
While the managers have a benign view, they added that there are some clear indicators that investors can monitor to ensure that liquidity is still under control.
Warning signs would include: a widening out of the FRA-OIS spread (or the difference between inter-bank lending rate and the overnight index rate), which suggests a rising cost of term funding for banks; dollar basis swap spreads rising, which indicates dollar funding costs are rising; and the effective Fed funds breaking out of the corridor, showing the central bank is “losing control”.