Don’t worry about the end of the cycle, worry about the what could cause the next global financial crisis, warned Hermes head of fixed income Andrew Jackson.
There has been a lot of focus on when the end of the economic cycle will come and when we will see a downturn in markets.
A typical cycle lasts between 7-8 years and the current bull-run is the second-longest in history at almost a decade; so if history serves us well we should be due a change in the near future.
Jackson did admit that we are seeing some signs that normally appear at the end of a cycle such as leverage increasing and covenance getting looser but isn’t convinced that it is upon us yet.
“Not everything you’d expect to see at the end of the cycle is occurring and I don’t think you can be definitive about where we are in the cycle because there are significant differences in different sectors, significant differences in different markets and significant differences geographically and jurisdiction-wise,” he said.
What does worry the bond manager, however, is the sudden onset of an event similar in magnitude to the 2008 financial crisis.
From 2007 to midway through 2009, credit sectors such as the IA Sterling High Yield, IA Sterling Strategic Bond and IA Sterling Corporate Bond were all in negative territory, not too far from the global equities index, as the below chart shows.
Performance of global markets during financial crisis
Source: FE Analytics
“What I’m really worried about is the really, really big turn in markets. The like of the financial crisis. But it could be five years before it happens,” he said.
He is convinced that such an event will happen, noting: “The reason it’s going to happen is we’ve just been through the largest financial experiment in history, the most coordinated financial experiment in history. The like of which has never been experienced if you look at your history books. Nothing even close to this has ever occurred.”
What worries him the most is that he doesn’t think anyone will predict how this event will happen, what will cause it to happen, or when it will happen.
“You don’t expect really, really big blow-ups, the like of the financial crisis. They come so fast, they hurt you so badly, they cause you so much pain. The reason they do is because you’ve been conditioned to expect that this could never happen again.”
Jackson said those that have faith in the US Federal Reserve and the European Central Bank to handle such a situation are not thinking outside the box and considering exogenous factors.
However, it wasn’t all negative and Jackson did praise the Fed saying he thinks it has been as close to perfect as possible with its monetary policy of late.
Indeed, both US bond and equity markets have had a smoother ride than many investors would have anticipated since the Fed starting hiking rates in December 2016.
Performance of S&P 500 and US 10-year Treasury since December 2016
Source: FE Analytics
He noted: “I think they’ve done an absolutely fantastic job of exiting a really, really hard situation of flagging and signalling and being very judicious and the market is pricing in further rates moves.
“And that’s really good because the market has not absolutely blown up in pricing in those moves and that was one of the things everyone was talking about.”
If and when an event occurs to plunge us into another crisis, one of Jackson’s main worries is default rates and in particular the recovery rates investors can expect to achieve on those defaults.
“I think what we’ve seen, because the cycle is much longer, is that recoveries will be ugly,” he said.
“Where will they be ugly? If I had to look for one area, probably US CCC, where default rates are going to go up and people are just going to get absolutely smashed on recovery because there’s no security.
“There are no assets behind some of these companies anymore and asset-light companies are highly dangerous as you’re lending on cash-flow.”
Another potential pitfall is Jackson’s outlook for fixed income after Brexit. He thinks the drawdowns of a bad deal would be worse for fixed income than the positives of a good deal.
In the event that the UK can secure a fantastic deal, he said that “fixed income markets will probably appreciate slightly.
“But they are not pricing in a really awful deal. There is not a huge Brexit premium within the UK. There’s a small Brexit premium but not a huge Brexit premium, which I think probably tells you, on balance, if there is no deal and the conservatives tear themselves apart, which is what happens next, then I think we could see UK fixed income off a decent amount.
“I think that’s now a possibility more than it was post-referendum because post-referendum the reaction was actually very muted.”
On the other hand, there are pockets of fixed income that he likes at the moment and one is European BB.
Assessing the asset class as a whole, Jackson is feeling positive: “I actually feel pretty good about a lot of areas of fixed income markets.”
Looking at the here and now – rather than forecasting the future – Jackson said that the correction that markets are currently undergoing is no cause for concern, adding that currently global default rates are low, volatility is still low and there are many opportunities out there.
Performance of global bonds year-to-date
Source: FE Analytics
However, the world of fixed income is changing and there are some big trends, according to the bond manager.
“The really big trends are that investors have moved to either one end or the other end of the liquidity spectrum in credit,” he said.
“So, people are either daily investors in credit ie. they only invest in UCITS funds with daily liquidity, or you have a much more sophisticated investor base who’s now getting much more comfortable doing less liquid stuff.”
Less liquid stuff includes direct lending, real estate debt, student loans, basically everything that isn’t “really vanilla lending”, he explained.
Jackson thinks that it is a big positive that investors are moving into illiquid fixed income markets because the banks aren’t able to do a lot of what they used to thanks to more stringent regulation.
While a lot of this illiquid debt would once sit on a bank’s balance sheet, it now migrated to pension funds, he said.