Market Views: Fixed Income
Are the doom-mongers right about market risk?
China’s slowing economy and the weakening oil price have led some investors to believe bigger problems are brewing for financial markets. Gareth Isaac believes that investors should be cautious in 2016, but shouldn’t throw in the towel just yet.
Unstructured Learning Time
A late wakeup call
The level of risk within financial markets, generally, has undoubtedly risen. But that shouldn’t come as a shock to investors.
Following the financial crisis, central banks reduced rates to zero (and in some cases below zero), and embarked on colossal quantitative easing (QE) programs to support markets.
At any sign of a wobble, they have been at hand to provide further stimulus and accommodation. That dynamic is now coming to an end.
Policy makers in the US are now beginning to raise rates, and the UK may follow suit later this year. This period - when support is withdrawn - was always going to be volatile.
A rising rate environment will have wide-ranging consequences for financial markets.
As QE has pushed bond yields to historic lows, corporate finance chiefs have taken advantage of the low yield environment, to refinance and add debt to corporate balance sheets at very attractive rates.
Less liquidity will see the cost of capital rising. Companies will have to compete more aggressively for finance.
Those companies in challenging markets or with poor business models will find it much more difficult to attract capital.
Default rates will certainly rise - even outside the resource sector - and investors should be prepared for that.
Clearing dead wood
In our view, QE has delayed the healthy process of ‘creative destruction’ within the corporate sector, to the detriment of productivity and innovation.
As rates rise and credit spreads widen1, the process of creative destruction can begin, and that actually improves the medium-term growth outlook.
Regarding China, we don’t see the cataclysmic 2008-style ‘credit crunch’ forming that some market participants do, but that doesn’t mean that we are not concerned.
There are significant risks. China now accounts for approximately 17% of global GDP; up from 10% in 2005.
Any material slowdown in the second largest economy in the world would have significant ramifications for the rest of the globe.
China is attempting to make the transition from a manufacturing-led economy to a service-led economy – a transition that took the UK generations – in a decade or so.
That process is not going to be without difficulty, and the Chinese authorities are learning as they go. Mistakes will happen.
China will continue to grow, but the composition of growth will continue to evolve.
Manufacturing growth is diminishing as a proportion of total growth, and the service side of the economy is flourishing.
The problem for the rest of the world is that the service side of the economy is domestically driven, and thus has a much lower impact on the global manufacturing supply chain.
It is infrastructure spending that drives the prices of commodity and raw materials. The growth of Alibaba, for example, doesn’t.
As the service sector grows relative to the manufacturing sector, the challenges for emerging markets that supply raw materials will remain.
Not all debt is created equally
The other challenge that China faces is debt.
Chinese state-owned enterprises have built up an enormous amount of debt over the past decade.
The debt is concentrated in industries that have over-supply issues, and is unlikely to be paid back.
If China was a more traditional, open economy, then these companies would fail and the debt would be wiped out.
However, in China the companies are kept alive with state intervention to preserve jobs, extending the debt out with the help of state-owned banks.
That’s not to say that the debt is not a serious issue. It is, but the usual time pressures do not apply to the same extent.
China is in a better position to slowly deflate the debt issue over time.
The oil dividend
These pressures mean that the outlook for emerging markets remains fragile. The decline in commodity prices, and especially oil, has surprised us.
The fall in price has forced producers to pump more oil; exacerbating the supply glut and pushing prices even lower.
It has been a vicious cycle. We do however believe that the price is getting close to the bottom.
The supply-demand dynamics should push the cost of oil higher as we move through 2016.
Although there will be further distress in commodity producers and the bonds issued by them, the lower oil price should continue to support household incomes in the rest of the world.
Developed economies look conflicted
Developed economies face countervailing forces heading into 2016.
The worsening global outlook in the second half of 2015, and the subsequent impact this has had on financial conditions, are battling against the extremely robust consumer.
Widening credit spreads and some signs of increased risk-aversion from the private sector are competing with low oil prices, good employment growth and rising wage pressures.
The contrast is most obvious in the US.
The US consumer is saving more (risk aversion) at the same time as net wealth improves (disposable income is increasing).
This is unusual, and it is causing some puzzlement. This dynamic could also create upside risk to economic forecasts if the normal relationship resumes and the savings rate begins to fall.
In the long-run, however, any society’s ability to enrich itself is almost entirely dependent on its ability to increase productivity, measured as output-per-worker or output-per-hour.
On this, the post-crisis experience has been disappointing.
While there are structural forces at play pushing down productivity growth, it does appear that there has been a cyclical element to this too.
With wages beginning to rise - especially in the US - the primary challenge facing developed economies will be to return productivity to nearer pre-crisis levels.
1. Yield spread, or credit spread, is the difference in yield between different types of bonds (for example, between government bonds and corporate bonds). ↩