It has been a much better year in 2023 for investors than in 2022 as the rise of artificial intelligence has bolstered tech stocks, which have led the market higher. Indeed, the MSCI World has made 6.3% so far this year, reversing some of its 7.8% losses made in 2022.
Bonds – represented by the Bloomberg Barclays Global Aggregate index – are on course to fall for the third year in a row, however, with the benchmark down 4.1% so far this year, having made losses of 5.7% and 3.8% in 2022 and 2021, respectively.
But there are other areas that could spook investors as we head into the final part of the year, according to experts, who below highlight their biggest concerns.
A bond market revolt triggering a stock market collapse
Staying in the fixed income sphere, Barry Norris, portfolio manager of the VT Argonaut Absolute Return fund, said there has been a “bond market revolt” against government spending at a time of full employment, as evidenced through the current ‘disinversion’ of the US Treasury yield curve.
“The Fed, which owns $5trn of US government debt, is currently reducing its holdings by $95bn per month – or $1.14trn annualised. Foreigners own $7.7trn – notably Japan at $1.1trn and China at $835bn – but can no longer be relied upon to recycle capital into Treasuries,” he said.
With some $5trn – or 20% of US government debt – currently in bills maturing over the next 12 months, there is a $4trn implied net imbalance in the US Treasury market that will need to be plugged.
“This funding gap compares to current institutional investor ownership of US government debt of just $8.8trn. In other words, investors must continue to feed the Treasury deficit beast. This has the potential to cause a 1987-style stock market crash,” Norris warned.
Watch out for short-dated bonds
Arif Husain, head of international fixed income at T. Rowe Price, agreed that there was a supply imbalance, and warned that bonds with a shorter maturity date could be under fire, having performed well in the rising interest rate environment.
“While we believe short-dated fixed income is attractive in many places, we hold serious concerns about the long end of many global government bond markets. Governments around the globe will need to boost sovereign debt issuance to pay for ballooning fiscal deficits, largely as a result of Covid-era policies. Yields will need to increase across the board to attract buyers to take up the flood of supply,” he said.
This could also feed into the corporate bond space as an influx of high-quality government bonds coming to the market should – in theory – dry up the interest in corporate bonds unless the yields are increased.
“This would raise the cost of funds for corporations and make them less likely to spend on capital projects or hiring more employees, removing a vital source of support for the global economy just when it needs it most,” he said.
High yield and emerging market debt under pressure
Gaël Fichan, senior portfolio manager at Syz Group, also warned on high yield bonds, the most risky part of the fixed income market.
These tend to pay a better yield, making them attractive to investors in the low interest rate environment of the past decade, but with yields on the up, some are concerned that these companies could no longer be able to service their debt.
“High yield bonds could come under pressure in this very uncertain environment. Recession fears, expectations of higher default rates and one of the most aggressive monetary policies are expected to weigh on this segment. The current US high yield spread implies modest default rates and the absence of inflation slippage, or a near-term recession,” said Fichan.
“In emerging market debt, we maintain a vigilant stance due to valuation and potential risk considerations. Higher oil prices and a strong US dollar pose challenges for oil-importing nations, especially Asian countries, while some Latin American countries may benefit.”
Risk assets beware the harbinger of doom
While the above managers were looking at the fixed income space, Toby Hayes, portfolio manager of the Trium Alternative Growth fund, was concerned about what he referred to as the “harbinger of doom” – repo accounts.
“A foreboding shadow looms over the global financial markets, casting doubts about the sustainability of the economic recovery and raising the question: is a market crash on the horizon?” he asked.
“Unseen, lurking in the shadows, lies perhaps the greatest harbinger of doom: the repo account. This account held at the Fed was the ultimate destination of roughly half the central bank’s quantitative easing (QE) printing. Money-market participants used it to stash newly printed cash and earn a measly pickup over the now long-forgotten zero yields.”
As this money has flooded back into onshore markets over the past few months and, in the process, supported credit and equity markets, the manager argued that it is perhaps the only reason US equities and credit have held up so well.
“But in a few months, the money will be spent, and the dollar liquidity feast will quickly turn to famine. Risk assets beware,” he said.
The US deficit needs to get under control
Lastly, Jeffrey Gundlach, chief executive of DoubleLine Capital, warned that the “massive” budget deficit and increasing interest rates on the national debt should “scare” Americans.
The budget deficit has risen from 3.5% to 7.5% of GDP, which is near the level at the depths of the global financial crisis, he said, while the interest rate on national debt could rise to 5.5% over time.
“This would increase the interest expense to $1.8trn annually, more than double the current defence budget. In just over two years, the interest expense has risen from $500bn to nearly $900bn. This interest expense is already far more than our entire defence budget,” said Gundlach.
“Should the Federal Reserve continue to raise rates, which may happen, or should the national debt grow, which is certain to happen, this problem will get much worse. The future of the US dollar and possibly out-of-control inflation depends on getting the budget and spending under control.”