Views From the Floor

Over the past few months, we have argued that we think the cycle still has some way to run. This week, we highlight developments that could prove otherwise.

In this week's edition: the cue from this floor is that there may be life in the old bull yet; and why European equity yields could be a silver lining.

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In this week’s edition: no confidence and the pound; don’t jump the gun; who owns what?; and liquidity and market stress indicators.

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While we don’t think there is a risk of an immediate US recession, some factors could be signalling trouble ahead.

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The Case for the Prosecution

Backing one’s judgement is a key skill in investment management. But, it is fatal to fall into the trap of believing you are right all the time. Over the past few months, Views From the Floor has argued that we think the cycle still has some way to run. Below are four reasons why we could be wrong.

First, purchasing manager’s index (‘PMI’) data in the US and Europe is getting weaker. Eurozone PMI for manufacturing and services came in at 47.8 and 53.4, respectively, in June. For the US, the readings are 50.1 and 50.7, respectively. (A reading below 50 would indicate a contraction.) Figure 1 shows that three out of the four PMIs have dropped sharply in 2019, with only the Eurozone services PMI bucking the trend.

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Second, the US yield curve is flattening. The spread between the US 2-year yield and the 10-year yield has ground remorselessly lower over the last few years, down to 28 basis points as of 27 June 2019 from 172bp on 26 June 2015.1 As an inverted 2-year 10-year yield curve has predicted all of the last seven recessions, this particular measure of the curve is favoured by some of our managers. We would also note that the 3-month ten-year yield curve first inverted during March this year, briefly recovered and has been inverted since May. The ability of the yield curve to predict recession was first documented by Professor Campbell R. Harvey, Man Group’s investment strategy adviser. His analysis shows that the yield curve projections of a recession’s probability hit more than 80% in the 1970s and 1980s, then settled into the 40%-50% range for the last three recessions. As of 4 June, the yield curve implied about a 40% probability of a recession.

Thirdly, the growth of money supply in the US is slowing. According to the St Louis Fed, real M12 declined from USD1.488 trillion in February to USD1.486 trillion in May. Nominal GDP is a function of the size and velocity of the money supply: GDP = M x V. A reduction in the size of the money supply would need to be compensated for by increased velocity, and is unlikely to bode well for growth.

Finally, companies whose business models are sensitive to economic downturns are showing signs of slowing growth. In particular, we monitor a few companies that are currently showing the first signs of a slowdown: a temporary employment agency (temporary staff are usually the first to be let go) and a leading specialist distributor of plumbing and heating products (implying business and households are delaying capital spending and maintenance).

Ultimately, we still believe we haven’t reached the top of the cycle, but there are good reasons why we may be wrong. Running the counter argument is useful for challenging our views and hopefully avoiding hubris.

Credit at the End of the Cycle?

Since 2017, we have observed headline credit indices moving in reaction to the implied Fed Funds rate (Figure 2). As the implied rate is now below the effective rate, we would expect credit spreads to widen, as fears of credit cycle contraction mount.

However, this isn’t playing out in practice, and the market appears to be under-pricing any probability of a default cycle, in our view. Credit indices have rarely been tighter post crisis, with the Markit iTraxx Europe Crossover index at 262.01 as of 27 June.

This is odd for three reasons. First, hard and soft economic data from around the world has been grim in the past few weeks (including, but not restricted to: weak PMIs as mentioned above, weak May Chinese activity data and University of Michigan inflation expectations at an all-time low). Second, sector and bond dispersion, as measured by the dispersion between the 10th and 90th percentiles is likewise increasing, which in our view indicates issuer and segmental distress. (Figure 3). Third, the credit expansion since 2008 is the longest on record, and cannot, in our view, last forever.

We believe this is the result of quantitative easing and an easy monetary policy environment. Because interest rates are low, fewer companies are going to the wall. Our view is that QE is having the systemic effect of delaying the default cycle, for all but the very worst companies. Furthermore, we would argue that this leaves the market structurally vulnerable to a pick-up in default expectations, particularly given the tight starting point for credit spreads.

Figure 2: Effective Fed Funds Rate Versus January 2020 Implied Fed Funds Rate

Effective Fed Funds Rate Versus January 2020 Implied Fed Funds Rate

Source: Bloomberg, Man Group; as of June 2019.

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With contribution from: Ben Funnell (Man Solutions, Portfolio Manager), Moni Sternbach (Man GLG, Portfolio Manager) and Chris Huggins (Man GLG, Portfolio Manager).

1. Bloomberg.

2. The money supply that encompasses physical currency and coin, demand deposits, traveller’s checks and other checkable deposits.