The world is unlikely to be headed towards a repeat of the financial crisis any time soon but that does not mean it will be all plain sailing from here, according to AXA Investment Managers’ Chris Iggo. 
On 22 August 2018, the US stock market celebrated the longest bull run in its history after the S&P 500 went 3,453 days without a 20 per cent correction. The US bull market has been in play since 3 March 2009.
However, 22 August also marked the 10th anniversary of a speech by then-Federal Reserve chairman Ben Bernanke. At the 2008 Jackson Hole central bank conference, Bernanke’s ‘Reducing Systemic Risk’ speech examined the deteriorating economy amid tightening credit conditions.
Of course, this was the time of the breakdown of the US sub-prime mortgage market, the rescue of Bear Stearns and the looming collapse of UK lender Northern Rock. Just a few weeks after Bernanke’s speech, investment bank Lehman Brothers filed for Chapter 11 bankruptcy protection.
Performance of index since 3 Mar 2009 in US dollars
Source: FE Analytics
Iggo (pictured), chief investment officer for fixed income at AXA Investment Managers, said: “As we now know, Bernanke’s valiant attempt to suggest that governance and oversight of capital markets was being strengthened was too late to prevent the biggest financial collapse in modern history.
“Post-Lehman, credit spreads blew out, equities went into a bear market and the economy entered a deep recession.”
He added that there are some “interesting macro observations” from the period that could seem comparable to today’s market conditions: The US economy peaked in 2007’s final quarter, almost a year after the unemployment rate bottomed out at 4.5 per cent; the S&P 500 hit a record high in October 2007 despite the credit crunch; and the yield curve had inverted in 2006.
“That period saw the worst financial crisis and deepest recession that most of us have ever seen and hopefully will never see the likes of again. It is an extreme benchmark against which to compare what might happen when the current expansion does eventually come to an end,” he continued
This week the S&P 500 index hit another record high and is closing in on a decade-long bull market. That, together with the length of the US economic expansion, the steady (almost complete) flattening of the Treasury yield curve, the rolling over of growth in other parts of the world and the more volatile political environment leads many to conclude that the 10th anniversary of the recession that followed Lehman will be marked by the beginning of another recession.”
On the one hand, bulls point out that equity valuations are being supported by relatively robust economic growth, ongoing investment in technology and persistently strong earnings growth.
Bears, meanwhile, highlight the tightening monetary conditions as quantitative easing (QE) is rolled back and interest rates start to rise along with the potential negative impact of increased trade protectionism as reasons why the market run could be under threat.
Iggo sees a number of positives within markets. For example, current consensus forecasts have the S&P 500’s earnings per share growing by 22 per cent over the coming year while dividends are tipped to rise by 10 per cent. Meanwhile, the crisis prompted increased regulation and governance in financial markets compared with conditions a decade ago.
“When Lehman collapsed 10 years ago the US economy was already slowing and the Fed had started to ease. While some people worry about leverage in credit and high valuations in equities, it’s hard to see any kind of repeat of the great financial crisis,” the bond CIO argued.
Performance of indices in 2008 (in local currencies)
Source: FE Analytics
“But that doesn’t mean there won’t be some problems down the line. The US expansion is long, the stock market is at record highs, monetary policy tightening has further to go and positive sentiment on the economy and earnings is having to deal with waves of negative sentiment coming from the world of politics.”
When it comes to the bond market, Iggo pointed out that it remains in a low yield environment and it is “not very exciting” when it comes to pure carry plays, or the returns that a bond investor gets from the coupon income alone.
This has been the case for some time and it shows in 2018’s bond market returns. Over the year to the end of July, the best performing bond sector was US high yield with its 1.2 per cent total return; the worst was emerging market hard currency debt, which was down 2.8 per cent over the same period.
“Despite US yields having risen, the asset class remains quite expensive,” he added. “It’s been difficult to get positive returns so far this year and there remains the distant possibility of a more pronounced bond bear market.
“The best hope is that inflation remains benign and default rates remain low so that bond investors can continue to eke out carry where they can find it with a minimum of downside risk.”
Emerging market bonds have been hampered by the crisis in Turkey, which has been exacerbated by a sizeable current account deficit, a large pile of foreign currency denominated debt, high inflation and a political system that has concentrates decision making in the hands of a strong ruler.
But aside from Turkey and “a mini-crash” in Chinese high yield in July, the summer months have been relatively quiet ones for bond investors, according to Iggo. The rest of 2018 might not have the same sense of calm, however.
“There is likely to be more noise at least in coming months with lots of chatter about the Italian budget, the impact of the end of QE in Europe, China’s ability to deal with trade protectionism, and Brexit. Personally I don’t get the sense of any impending big moves in bonds in the short run,” he added.
“But who knows? There has apparently been a record high volume of short positions in the US 10-year Treasury futures contract with some investors clearly looking for an eventual break above the 3 per cent level that has been resilient so far.”
Performance of US treasuries over 5yrs
Source: FE Analytics
Over the long run, however, the AXA IM bond CIO cannot rule out a bear market for his asset class and pointed out that “fixed income has been expensive for some time”.
Government bond indices have more duration than ever for some of the lowest yields in their history. Meanwhile, the share of BBB-rated securities in high grade credit indices has risen steadily but spreads have fallen close to their lowest levels.
“Arguably, across the fixed income spectrum investors are not fully compensated for the fundamentals risks – inflation, rates increases and credit deterioration/default. But it has been this way for ages, supported by the central bank put which is only slowly being taken away,” he concluded.
“Over time, valuations will adjust, especially if the global expansion does deliver higher inflation – US CPI inflation at 2.9 per cent is now at its highest level since 2011 and definitely in the higher 50 per cent of the range of inflation outcomes since 1990 – or, alternatively, a slowdown raises credit risks. There will continue to be that distant dark cloud of a more pronounced bond bear market.”