Could Middle Eastern uncertainty and QE wind-up drive a return to normalization?
With the Middle East coming back into the global political spotlight, it’s a salutary time to look closely at oil. The radical steps recently taken by Crown Prince Mohammed bin Salman to modernize Saudi Arabia may well end up bringing benefits to the region, but it’s difficult to believe that there won’t be bumps along the road to reform. We’ve already seen turbulence in Lebanon, with the dismissal and then reinstatement of the Prime Minister this month, while the conflicts with Yemen on one flank and Qatar on another seem little closer to resolution.
Given the uncertainty in Saudi, it’s not surprising that oil has risen to its highest level in more than two years1. Even without bin Salman’s purge, there were a number of forces acting to push oil higher: from the melt-down of Venezuela (which has the world’s largest store of proven oil reserves) to the natural cyclical upswing coming from strong global growth. It also seems increasingly clear as we move towards OPEC’s next meeting at the end of this month that there are no plans to moderate the supply cuts that have been put in place in an effort to address the supply glut that was one of the factors that initially drove prices lower. If anything, the cuts appear likely to be prolonged past the current March 2018 deadline.
Oil’s latest jag higher has taken place against the backdrop of the continued tightening of bond yields. While we’re not quite back to the negative levels of mid-2016, German government yields have narrowed sharply in recent days2, a sign of the seemingly endless buoyancy of investor sentiment, while a number of blue-chip corporations have issued long-dated bonds at or near to 0%. Investors appear Panglossian – continuing in their optimism, even as signs increasingly point towards a potential peak of the cycle. In this context, we think it’s worth spending some time thinking about oil, and the impact that a sustained bout of inflation could have on the global economy, and particularly on the bond markets. We’ve written before about the major threat that we believe lies in the specter of the return of inflationary pressure. It’s difficult for us to imagine that inflation won’t rear its head in the coming months; if and when it does, current bond yields may be looked upon as evidence of a profoundly overheated market.
In parallel to this, one of our portfolio managers, Ben Funnell, has done some in-depth work on another risk that we’d draw to investors’ attention: the unwinding of global programs of quantitative easing. Now it’s not as if this hasn’t been active on the market’s radar for some time, and so far the rolling off of the US asset purchase scheme has been largely trouble-free. But Ben’s team argues that it’s worth looking more closely at the absolute scale and potential ramifications of winding up.
Since 2008, central banks have added more than USD15tn to their balance sheets, led by the ‘Big 3’ of the US Federal Reserve, the European Central Bank and the Bank of Japan. This has suppressed risk premia, tightening yields and forcing investors into ever-riskier asset classes like emerging markets and high yield debt. As these asset purchase schemes cease, the private sector is going to have to step dramatically into the breach. As Figure 1 shows, this could amount to some USD3tn by the end of next year, working on the assumption that Europe begins to scale back its programme in March. It’s not an impossible figure for the private sector to absorb, but it will be a stretch, and in our view could mean a reversal in the seemingly inexorable tightening of bond yields.
Figure 1: Monthly changes in global aggregate central bank balances
Source: Central bank financial statements, IMF, Man GLG estimates. This research factors in the US Federal Reserve’s stated intention regarding its portfolio run-off, and makes estimations based on recent trends and central bank statements for other central banks. Light blue bars indicate start of estimation period, which begins in September 2017 due to delays in data releases.
Whether an increase in bond yields feeds through to weakness in the equity markets is as yet unclear. There are numerous reasons to be positive about the global economic outlook – growth rates are decent, earnings are robust and estimates being nudged upwards, policy interest rate hike expectations are being revised down – but the current bull market feels like it’s a tide lifting all ships, regardless of seaworthiness in our view. This poses clear challenges for those who, like us, have long-short investment strategies as a significant part of their approach to the market.
As an example, our team spent some time earlier this year performing analysis which differentiated between those utility companies which benefit from rising commodity prices and those whose cash flows are government regulated and are therefore often seen as bond-proxies. Our belief was that we were moving into an inflationary environment in which commodities would rise while bonds (and firms with cashflow profiles that make them behave like bonds) would suffer. Of course, we actually saw commodities rise and bond yields fall, something which to us feels intuitively wrong.
What has happened is that, given that the traditional bond markets have tightened to levels that are – to use a well-worn word – unprecedented, investors are attempting to achieve bond-like return profiles from other investments. The highly regulated, traditionally defensive and predictable energy firms have been caught up in this rush to forge bond-substitutes, meaning that their prices have been chased up to what we view as unsustainable levels. These are firms that are particularly exposed to political risk – look at the performance of British utilities since the Conservative government began to ‘get tough’ on energy pricing. Slowly, we believe that rationality is returning to the markets, and that this relationship, like many others that have been skewed by the wall of money chasing yield, will be re-established. It may, though, take more Middle Eastern turmoil, or a wider recognition of the scale of the QE hole that needs filling, for the markets to truly normalize.
1. Source: Bloomberg, as of November 6, 2017.
2. Source: Bloomberg, as of November 6, 2017.