By Rom Badilla, CFA
As a follow up to yesterday’s article, "Stocks Further to Fall if Bond Yields Have Their Say," here is another tidbit of information that may keep the equity and other risk asset bulls up at night.
According to Deutsche Bank, equity fund managers have lowered their exposure to risk assets on concern of the Fiscal Cliff. In their Asset Allocation: Investor Positioning and Flows report released on November 12, 2012, the strategist team led by Binky Chadha wrote the following:
On the heels of the U.S. election, fund managers have gone very underweight risk assets as concerns about the fiscal cliff intensify. Our measure of overall equity positioning (composite beta) is near three year lows after hitting a high just a month ago.
Composite Equity Beta & S&P 500 (Source: Deutsche Bank)
Beta is a measure of portfolio exposure in relation to the market which for many fund managers is the S&P 500. So a measure of 0.0 means that their portfolio will have little correlation with market performance while a positive Beta means it should follow it closely. Conversely, a negative Beta means it should do the exact opposite of the market.
As you can see with the graph, the Composite Equity Beta is well into negative territory suggesting that fund managers are negative on stocks. If the situation with the Fiscal Cliff escalates further, you can expect less support from fund managers until they switch their stance on their portfolio positioning. The consequences could mean a sharp sell-off if an impasse becomes visible.
In regards to the bond markets, further weakening in stocks should be positive for U.S. Treasury prices where bond yields fall even lower. Last year’s debt ceiling debacle provides a blueprint for what to expect with U.S. Treasury yields.
On June 22 2011, the 10-Year was trading at 3.01%. On the following day, the debt ceiling discussions made a turn for the worse when an impasse in talks between both Democrats and Republicans failed to agree on proposed tax and spending cuts.
When a deal was reached on the debt ceiling to avoid a technical default at the end of July 2011, the 10-Year was trading lower at 2.77%. When Standard & Poor’s Credit Ratings downgraded the U.S. from ‘AAA’ to ‘AA’ on August 5 2011, the 10-Year yield fell further to 2.40%. So from the end of June to the beginning of August of last year, yields dropped more than 60 basis points on a flight to quality bid toward safe-haven assets.
While Treasury yields may rally in such a scenario, lower rated Corporate Bond yields may not. Again, history can be used as a guide.
The Barclays U.S. High Yield Bond Index took a major beating during this time period. Near the onset of the debt ceiling crisis on June 22, the credit spread or yield differential between the High Yield Index and U.S. Treasuries was at 5.49% or 549 basis points. On August 3rd, that credit spread widened to 573 basis points. When Standard & Poor’s downgraded the credit rating of the U.S., High Yield credit spreads gapped to 609 basis points on August 5th. The bleeding didn’t stop for High Yield as sellers emerged well afterwards as the credit spread reached 670 basis points on August 8th to a peak of 725 basis points only three days later. So from beginning to end, the credit spread on High Yield widened by 146 basis points.
BCS U.S. High Yield Index Credit Spread during 2011 Debt Ceiling Crisis
Suffice to say, the price for the High Yield index fell as yields failed to keep pace with falling Treasury yields. Over the course of both July and August, the Barclays U.S. High Yield Index lost 6.48% relative to their U.S. Treasury counterparts.
Whether its Equities or High Yield bonds, risk assets will fall if leaders fail to reach an agreement on the issues surrounding the Fiscal Cliff. The equity fund managers have positioned their portfolios to reflect this view. If pressures begin to mount due to further escalation of an impasse, you can bet that risk assets will have little support. At that point, I wouldn’t be surprised to see equities tumble and yields on lower rated corporate bonds to rise since falling off the Fiscal Cliff will most likely lead to an end of the current recovery and into a new recession.
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