If growth is picking up, why are bond yields still so low?
It appears the low volatility/high valuation regime in equity and credit markets is continuing into the autumn. This is despite an important and imminent US Fed balance sheet reduction announcement. Furthermore, October brings details of the ECB's plans to reduce the net purchases of its own QE program.
While central bankers are quick to claim credit for any improvement in economic conditions, the decline in long-term bond yields over the summer questions the durability of the expansion as the yield curve flattens. It also remains to be seen if investors will re-appraise the low level of risk premia in global markets as QE is withdrawn.
Exhibit 1:Elevated price/book multiples for equities and low junk bond spreads
It is not just stock market investors who are prepared to chase risk at present. Within the corporate sector there has been a meaningful re-leveraging of the median US non-financial since 2014. Forecast median net debt/ebitda for US non-financials has risen to 1.4x from 0.8x, Exhibit 2. We highlight the median statistic as this growth in leverage is partially obscured in the weighted average figure due to the large cash balances within a few large-cap companies in the US technology sector. Furthermore, EBITDA margin forecasts are at record levels which would be expected to depress the net debt/EBITDA ratio at this stage in the cycle; in our view it is therefore a concern to see leverage expand in this way while companies record peak profit margins and cashflow.
Exhibit 2: US median net debt/EBITDA rising post-2014
This increase in leverage is also happening at a time when there is a growing divergence between the Fed's dot-plot interest rate projections and futures-implied market expectations, Exhibit 3. Put more simply, fixed-income investors currently believe that the Fed will be forced to lower the trajectory of interest rate increases and by implication growth will be weaker than the Fed is currently forecasting. With 10y rates having fallen to 2.1% from 2.4% earlier in the summer, we expect the Fed to change tack, if only to avoid inverting the US yield curve, given its association with impending recession.
Exhibit 3: Increasing divergence between Fed projections and market expectations
Even if in part due Trump's failure to progress his administration's US tax reform and stimulus spending agendas a falling dollar, falling US rate forecasts and declining bond yields are all consistent with a slowing growth outlook for 2018. The US yield curve has flattened by 40bps since earlier in the summer. By facilitating the build-up of further indebtedness, US policymakers could even be said to be in a liquidity trap of their own making, as over a number of cycles since the 1980s the Fed has been unable to buck the trend of ever-declining interest rates.
We also observe that the puzzle of only modest US wage growth despite very low unemployment is less of puzzle if nominal wage growth is assumed to be on a declining trend. The pricing power of labour has been impacted by both de-unionisation and globalisation in recent decades, in addition to the increasing social acceptance of technology-led labour saving working practices.
From a cyclical perspective however, wage growth has been above the declining trend since 2014. Interestingly, if the 5-year periodicity of past cycles is a guide, US wages will be growing below trend by 2019 and the Fed will be cutting rates by spring of next year - which would be closer to current market expectations than the Fed's own projections.
Exhibit 4: US wage growth above long-term trend since 2014
A further mystery in respect of recent investor behaviour has been how policy and economic uncertainty has not led to rising risk premia in financial markets. Following Brexit and the election of Trump, there is another example in the significant turnover of officials at the US Fed over the next six months. Both the Chair and vice-Chair positions are potentially vacant in addition to 2 Fed governors. The temptation for Trump to appoint dovish individuals in respect of both monetary policy and financial deregulation may be difficult to resist. It is also understandable that some investors may view such a possibility positively for the short-term outlook.
This is even as for the longer-term, there is a clear consensus that the speculative excesses caused by lax financial sector regulation prior to 2008 ultimately proved highly damaging for risk assets and the economy. Balancing the short- and long-term considerations is therefore a challenge for investors. Even now, there is little clarity on which individual will lead the Fed - the recent favourite, former Goldman (NYSE:GS) COO Gary Cohn for now appears out of the running.
We believe there remains a significant degree of uncertainty in the economic outlook at present. However, because of the long period of asset price gains in this decade, investors are currently reluctant to demand increased risk premiums for risky assets for fear of missing out.
The US economic expansion is now one of the longest over the past 100 years and bond, dollar and interest rate markets are casting doubt on the Fed's sanguine view of the economy. Similarly, consensus earnings forecasts call for a further year of record profit margins in 2018 which offers in our view little scope for upgrades. The staff turnover at the Fed makes policy even harder than usual to forecast. Trump's policy agenda appears stuck in politics and would now would require an astonishing turnaround to become a meaningful positive for investors. We remain of the view that portfolios should remain cautiously positioned.