Investors should be wary of market risks such as widening credit spreads, a self-fulfilling meltdown and an evolution of global trade tensions, Principal Global Investors strategists have warned.
In a recent article, Principal Global Investors chief global economist Bob Baur talked us through the three macroeconomic risks that he is most worried about while chief investment officer Todd Jablonski highlighted the three biggest risks to portfolio construction.
Here, we turn to senior global investment strategist Seema Shah to discover the three market-focused risks that she believes investors need to have on their radars in the current climate.
Fund managers’ opinion on global corporate balance sheets
Source: Bank of America Merrill Lynch Global Fund Manager Survey
First on Shah’s list is the risk created by widening credit spreads. She noted that the record-low interest rates and extra market liquidity of the past decade has led to “a debt binge”, with BBB-rated corporate bonds (which are one notch above high yield) now accounting for around half of the investment grade universe in the US and Europe.
“Slowing growth and rising interest rates imply weaker profit growth, and corporates will face challenges improving their balance sheets after this significant increase in debt,” she said.
“If the Fed restarted its rate-hiking cycle and their balance sheet reduction continued, coupled with a continued economic slowdown, cash would become a viable asset class again, sharply squeezing credit when leverage is high.”
Shah warned that this could cause some issuers of BBB-rated credit to falter and drop into the high yield universe, which could create market liquidity problems.
Others share this view. Man GLG Strategic Bond lead manager Craig Veysey recently said that large swathes of BBB-rated corporate bonds could fall into the high yield index as higher volatility and worsening fundamentals prompt widespread credit downgrades in this part of the market.
Veysey said he was “very, very cautious” of those cyclical BBB- issuers that lack the flexibility to reduce the size of their balance sheet or increase their cash flow, warning that large numbers of them could fall into the high yield index in a relatively short time frame.
Shah told investors: “Be cognisant of the risks and focus on companies with strong balance sheets, wide profit margins, and stable revenues.”
Performance of indices in 2018
Source: FE Analytics
Last year saw volatility return to global markets after a period of historic calm. As can be seen above, most equity markets made losses – or flat returns – as investors fretted about issues such as trade wars, tighter monetary policy and slower economic growth
However, Shah is also worried by the risk of a self-fulfilling market meltdown: essentially a negative feedback loop where market falls prompt more investors to pull back from risk assets, thereby sparking more falls.
“Market tantrums can sometimes feed on themselves as confidence starts to plummet,” the strategists explained.
“If financial conditions deteriorate significantly further – perhaps because the Fed defies market expectations and resumes its hiking cycle this year – a period of negative market performance might weigh heavily on business and consumer confidence.
“This could raise the risk of recession, causing markets to tumble even further. Financial markets would not just be a leading indicator of recession, but a driver.”
Shah’s final area of concern is the risk that ongoing trade disputes between the US and China evolve into a “tech war”.
One of the biggest headwinds for markets last year was the tit-for-tat trade tariffs between the world’s two largest economies, which were initiated by the US as part of president Donald Trump’s ‘America First’ agenda.
The two countries have called a truce in the nascent trade war and are undergoing talks on its resolution, but the outcome is still some way off being determined.
“Trade discussions appear to be advancing, but recently the focus has shifted from China’s current account to China’s quest for tech domination,” Shah said. “Issues around technology and intellectual property take time and effort to resolve, and the technology sector is already feeling the heat.”
She pointed that recently introduced US controls of exports to a Chinese chip-maker suggest that investors should be extra-cautious of US technology sub-sectors like hardware and equipment, given their supply-chain exposure to China.
The strategist added that it seems likely the US will apply further pressure through export controls, which would have negative repercussions for the tech sector.
“How important could that be?” she asked.
“Between April 2009 and October 2018, earnings growth for the MSCI ACWI index, excluding technology, was just under 400 per cent, whereas the MSCI tech sector alone was over 950 per cent. If the tech sector stumbles, the broader market stumbles.”