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Hermes: The headwinds that could lead us into a “savage” bear market

09 March 2016

Eoin Murray, head of the investment office at Hermes, talks through the potential macroeconomic factors on the horizon that could make for the perfect storm and plunge us into the depths of a vicious global bear market.

By Lauren Mason,

Reporter, FE Trustnet

A perfect storm consisting of a US recession, a rise in global forced sellers and increased contagion risk could plunge risk assets into a particularly grizzly bear market in the near future, according to Eoin Murray.

The head of the investment office at Hermes says that, when it comes to bear markets, there are various different types that will have vastly different impacts on investors’ portfolios.

Markets were left wounded by negative investor sentiment halfway through last month as investors fretted about the plummeting oil price, China’s growth slowdown and other macroeconomic factors including the impending EU referendum in the UK and a lack of trust in central banks to fend off impacts of the economic cycle.

Markets have seemingly limped to a recovery now though, with the likes of the MSCI Emerging Markets and S&P 500 indices providing a positive total return since the start of 2016.

Performance of indices in 2016

 

Source: FE Analytics

However, Murray warns that investors aren’t necessarily out of the woods yet and points out that bear markets come in various forms and under multiple guises.

“The bear is not a homogenous beast. For example, the American black bear is a relatively timid animal compared with the more bellicose brown bear. Confrontation with either comes with risk, but the probability of injury depends on which species you encounter,” he said.

“Bear markets are similarly anomalous. They can take different forms, and the level of scarring investors may endure depends on their shape.  Broadly, there are two types of bear markets. The first is a ‘black bear’ scenario, which presents an injurious but relatively mild experience for investors.”

“This bear market tends to be shallower in nature. Markets may retrench 20 to 25 per cent, but the downturn will be relatively short-lived. Such bear markets occurred in the late 50s, the late 70s, and more recently over the summer of 2011.”


In contrast, he says the “brown bear” scenario is a much more daunting prospect for investors and typically involves a steeper market fall of between 40 and 45 per cent, which then takes far longer to recover from – the head of Hermes’ investment office uses the tech bubble burst and 2008’s global financial crisis as prime examples of this occurrence.

While he says that markets are still at risk of a “black bear” market, he warns that market conditions could easily teeter unfavourably over the near term and thus plunge markets into a far more ominous “brown bear” scenario. There have been numerous debates about the health of the US economy over recent months due to the release of negative economic data such as low home ownership and below-expected consumer spending despite the plunge in oil price.

In an article published last month, Royal London’s Trevor Greetham explained that the use of forward guidance by central banks has spooked investors and led them to believe the US economy is in a much worse state than it actually is.

“Jobless claims rise sharply in a recession and there’s no sign of this happening, so although we’ve had a weak quarter in growth in the US, the labour market data keeps coming in strong and it’s the best indicator of how strong the underlying economy is,” he pointed out.

“This is also why the Fed is likely to continue raising interest rates.”

However, Murray says that there is a real possibility that the US could enter a recession, which he says is particularly troubling because the region is such a dominant force within the global economy.

“There is a raft of data to show the manufacturing sector – an area which accounts for 25 per cent of the economy – is already in recession. But perhaps more troubling is recent research by Bank of America and Deutsche Bank, which looks at the slope of the two to 10-year issues along the yield curve. Traditionally when that slope flattens, it does so immediately prior to a full-blown recession,” he said.

“The slope is already down below 1 per cent, so on the raw numbers alone it is clear the slope is beginning to flatten. Yet the situation might be worse than at first glance. For structural reasons the now still positive slope may be false because we are so close to zero interest rates.”

“The Overnight Indexed Swap rate, which rebases the slope, suggests that the slope is very close to flat already – should that be the case, the likelihood of a full-blown recession increases to 50 per cent in the US.”


Another potential factor that could lead to a particularly torrid bear market, according to Murray, is a sudden increase in the amount of forced sellers in the markets.

He says that the current environment is rife with powerful investors which could easily find themselves in this position, including the likes of China following its weakening currency and its central bank’s determination to defend the spread between its on and off-shore currency. The head of Hermes’ investment office points out the region has already become a forced seller of assets such as US corporate bonds and US treasuries.

“We [also] have a growing mass of investment strategies that are targeting volatility control, such as risk parity in all its different flavours, and momentum-type strategies. By their very nature, should we see sharp crevices in the markets, we could see a major equity sell-off,” he explained.

“Completing the trident, we have oil-backed sovereign wealth funds. Last year, they were forced sellers of equities to the tune of about $220bn. This year, if the oil price stays in the $30 to $40 range they will likely be forced sellers of assets worth $400bn to $500bn.”

Murray says that this potential headwind lends itself to contagion risk, given that the markets likely to be affected are so significant. He describes this, combined with a potential recession in the US, as deeply troubling, and points out that if a key market event occurs contagion could spread across asset classes as well as regions. 

“In the event of an economic shock, a lot will depend on the fragility of markets – and to what extent they are undermined by forced sellers. But if this perfect storm brews, we could face a savage bear market,” he warned.

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