In this week’s edition: no confidence and the pound; don’t jump the gun; who owns what?; and liquidity and market stress indicators.
December 18 2018
No Confidence and the Pound
The received wisdom is that the market abhors uncertainty. With that in mind, one might have expected sterling to weaken as Tory MPs initiated a vote of no confidence in Prime Minster Theresa May’s leadership on the morning of December 12, and to strengthen when she won.
However, the reverse was true. Figure 1 shows that sterling rose by 56 basis points (bps) against the dollar just after 8am GMT when the vote was announced, and fell 61 bps just after 9pm on news that May had won. Against the euro, it rose 39 bps on announcement and fell 33 on May’s victory.
Moves in sterling will clearly be influenced by other factors in the future. However, this move is a specific reaction to the vote rather than wider macro factors. With May refusing to contemplate a ‘People’s Vote’, her removal could offer a way out of political paralysis via a second referendum. However, the PM’s removal would also heighten the risks of a disorderly no deal Brexit or a general election.
In our view, this highlights the unpredictability of Brexit and the dangers of oversimplifying what is a complex debate.
Figure 1. GBP/USD Currency Cross
Source: Bloomberg, as of December 13, 2018
Figure 2. GBP/EUR Currency Cross
Source: Bloomberg, as of December 13, 2018
Who Owns What?
As we head towards the end of the credit cycle, we feel it is important to consider exactly who owns the $3.4 trillion of sub investment-grade corporate debt. Part of what turned the 2008 sub-prime mortgage collapse into a worldwide crisis was the difficulty in assessing who was exposed to toxic debt. As the tide turns, it is therefore worth examining who is exposed to this sizeable, volatile asset class.
Figure 3 below shows the rough break down of sub investment-grade corporate debt. $1.1 trillion is currently owned by banks, with the remaining $2.3 trillion owned by a variety of asset managers and institutional owners. We do not traditionally think of asset managers as being a systemic risk – after all, asset managers traditionally don’t provide liquidity to the system in the same way banks do. In our view, however, if sub-investment grade corporate debt does fall in value, liquidity may dry up. Asset managers may then be forced to sell other assets in response, creating ripple effects in the equity markets and beyond.
Figure 3. Ownership of Sub Investment-Grade
Source: IMF, Morgan Stanley, Federal Reserve, Man Group; as of November 2018
Hence, it is worth looking at collateralized loan obligations (CLOs), a vehicle used by debt originators to tranche and sell sub-investment grade debt around the world. In its ‘Financial Stability Report’ the Bank of England (BoE) estimates that only a third of CLOs are held by international banks (Figure 4). The remainder are held by a combination of insurers, hedge funds and other asset managers. Some 17% of the roughly $750 billion CLO market is owned by unspecified ‘Asian investors’, according to the BoE’s figures. With very little visibility in this part of the CLO market, how this ‘black hole’ will react in the event of a downturn remains to be seen.
Figure 4. Estimated Holdings of CLOs
Note: Each square represents 1% of CLO market Source: Bank of England ‘Financial Stability Report, November 2018.
Yield Curve Inversion: Don’t Jump the Gun
In our view, an inversion of the US 10-year 2-year yield curve remains a reliable indicator of the end of the cycle. In all of the last seven cycles, the inversion of the yield curve has preceded recession. However, we would caution that recessions do not perfectly coincide with market corrections: inversion has not immediately led to a market collapse, and the penalties for being an early bear can be quite severe.
Figure 5 below shows the return of the S&P 500 during each cycle, from the end of the month in which the yield curve inverted to the end of the month in which the index peaked. In six out of seven instances, the S&P 500 returned more than 10% between the yield curve inversion and market peak (in 1973 the market peaked before the curve inverted). These six cycles saw an average gain of 17% between the inversion date and peak date. Critically, it was an average of 13 months between inversion and market peak during these six cycles.
As of December 12, the spread between US 10-year and 2-year Treasuries was 12 bps, so we are not quite at the point of inversion yet. If and when the yield curve does invert, it may be some time before the effects of a recession filter through to the stock market.
Figure 5. The Lag Between Inversion and Market Peak
Source: Man GLG, as of December 2018
Liquidity and Stress
To gauge the magnitude of pressure on markets, we monitor a range of liquidity indicators, of which six are presented below. In our view, none of the indicators have shown the rapid rise with which we would typically associate with conditions of market stress and a lack of liquidity1.
The 3-month USD LIBOR-OIS spread provides a proxy for liquidity risk in the US banking system. As we can see from Figure 6, spreads ballooned during the Great Financial Crisis (GFC), but have remained below 50 bps during less stressful periods. Although we have seen a modest uptick this year to 40 bps, we have not seen the rapid rise which could indicate systemic stress. The 3-month FRA-OIS spread, the European equivalent, is at 4.9 bps. This is actually lower than the 5.1 bps spread of September 28, despite market turmoil since September.
The cost of insurance on both investment-grade and high-yield corporate bonds has also failed to spike. The Markit CDX North American IG Index, which tracks the cost of investment grade credit default swaps (CDS), is at 80 bps. The corresponding high-yield index is at 420 bps. While both indices have risen this year, neither is above their 2011 or 2015 highs, implying fears about the creditworthiness of US corporations have not yet fully crystallised.
The cost of a CDS on Morgan Stanley is at 51 bps, after a steady decline since 2011. After spiking in late 2017 and again in 2018, the cost of a EUR-USD basis swap has since declined to 15 bps, down from 44 bps on October 31 this year. In our view, this provides useful context: global markets may be down, but it appears we have a long way to go before investors show signs of liquidity panic.
Figure 6. Six Liquidity Indicators
Data for all our indicators is presented up to December 11, 2018
With contribution from: Giovanni Baulino (Man GLG, Portfolio Manager), Ben Funnell (Man Solutions, Portfolio Manager), Henry Neville (Man Solutions, Analyst), and Andrew Stone (Man GLG, Analyst).
1This opinion is strictly that of the manager. Future market conditions may be impacted by a variety of factors and we make no guarantee of their outcome. Investment decisions should not be made based upon this information.
The next edition of ‘Views From the Floor’ will be published on Tuesday, January 15. Until then, we wish you a wonderful holiday season and a happy New Year.