Wednesday, January 20, 2016

Final Innings

                Over the last few years, candidates for being the harbinger to the end of this bull market have come and go. We’ve had the Grexit crisis, China collapse, tech 2.0 bubble, property bubble, and much more that have growled, only for the market to yawn and keep rallying. But over the last month, a more interesting candidate has surfaced, which has been overshadowed by the scare about a China collapse: high yield bonds, formerly known as junk bonds.

In mid-December, 2 high yield funds halted redemptions to avoid liquidating assets in a fire sale: Third Avenue’s $3bn Focused Credit Fund and Stone Lion’s high yield fund. In other words, there simply is not enough liquidity in the high yield space to meet any type of selling. Illiquidity in the bond market has been well flagged this year; if even the IMF warns about this (in Sep 2015), you can be sure everyone knows. While the market has more or less shrugged this incident off, it’s a warning shot to risk assets. There’s no need to panic just yet, but it’s become clear where the risk is.

The underlying cause for all of this undoubtedly is low interest rates and leverage. The risk curve shifted down and money went to all types of yield seeking assets, including property, dividend stocks, higher yielding currencies (ie emerging markets), and of course high yield bonds. Other examples of an outcome of ultra-low interest rates are unprofitable ‘unicorns’ as well as companies issuing debt for share buybacks. Simple reversal means money flows the opposite way. For assets which are leveraged, like REITs, high yield bonds, problems become magnified. Today one of the issues is energy prices collapsing from >$100 to <$40 in over 1 year, dragging down the high yield market where it is ~14% of the market. While energy high yield bonds itself may not bring down the entire market, increasing rates over the next year or two will undoubtedly cause problems for the high yield market.

While pundits continue to worry about the slowdown in growth in the USA, they really don’t need to with unemployment close to NAIRU and wage growth picking up. Walmart is a key example where they have raised minimum wage to $9 and then will further raise to $10 by February 2016. They didn’t necessarily want to, but they needed to with labor market competition increasing. While costs will rise for companies, ‘main street’ will benefit and start spending their excess savings. Add that onto savings from lower gasoline prices, the USA will be doing just fine. For now, they are dragged lower by big oil cutting spending, but in the longer run the rest of the economy will benefit, starting from the consumer.

Which brings me to my final topic of discussion, the Fed’s pace of tightening. For the next year, the dot plot projects 4 rate hikes, which is exactly what the overall market is currently factoring in. Last I checked 10 year treasuries are trading at ~2%, which means market isn’t factoring in much of inflation at all. This is a huge risk for the market with labor markets tightening and wage inflation creeping up, as it could imply rate hikes quicker than market expects. You can be sure the market will not like that.

For the near future though, the market continues to choose to ignore these warning signs and misplaces their fears. The market is nervous, but not about the structural issues such as an overinflated high yield market and higher inflation. They’re still worried about things like China, ISIS, OPEC, crude oil, things that make the headlines but not the ones that will bring down the market. The market will continue to climb the wall of worry, until it finally faces the problem children of zero interest rates - and you can be sure high yield bonds will be one of them.