In the first half of this two-part series, we looked at some of the risks facing both U.S. and global markets in 2019, as told by the HSBC (NYSE:HSBC) strategy desk. Today, we analyze the second half of the report.
ECB initiates new unconventional policies
“The ECB might enter the next downturn with negative rates. Eurozone growth is slowing and core inflation remains low. With limited scope for fiscal action, the ECB might have to restart quantitative easing and, possibly, a range of other unconventional measures.”
With European interest rates still near historical lows, the European Central Bank (ECB) will have limited ability to counter a new recession with conventional monetary policy. The disparate nature of the countries within the EU also limits the efficacy of fiscal policy. Accordingly, the central bank may have to resort to less orthodox measures to inject liquidity into the system. As well as a fresh round of quantitative easing, these measures could include the ECB buying European equities, or changing the inflation target.
In particular, these measures would affect European banks negatively, as the flood of cheap money “shifts the balance of power from lenders to borrowers.” While this could boost European equities in the short-term, we would be entering uncharted territory and thus the level of uncertainty in the markets could also increase.
Leverage risks and accounting tactics
“US nonfinancial corporate debt is at its all-time high and average credit ratings of investment grade debt have fallen sharply. Elevated leverage and risk of higher funding costs point to debt servicing and refinancing challenges ahead.”
The double threat of increased borrowing costs and falling margins could prompt corporates to adopt “more aggressive accounting judgments and decisions.” Accounting departments can engage in sleight-of-hand like booking revenue early, deferring costs, not recognizing certain liabilities (for instance, not taking into account the worst-case possibility of a pending legal decision) and deferring large cash payments like pension contributions. U.S. corporate debt stands at over 45% of GDP, higher than before the 2008 crisis. This high amount of leverage combined with the pressure to continue to meet inflated analyst expectations could prove to be a combustible mixture.
The Fed keeps hiking
“We expect three more Fed hikes until June 2019. But core inflation could accelerate and the Phillips curve steepen, leading to a change in the FOMC stance.”
Increased borrowing costs could pose a serious challenge to companies with large amounts of short-term debt that would need to be refinanced. As the report makes clear: “If tightening is in response to tariff related inflationary pressures the impact on equities would be negative. Multiples would likely contract further in this environment, and this would not be offset by stronger earnings growth. Defensive sectors with strong balance sheets would in theory fare best”.
Additionally, a strengthening U.S. dollar could make U.S. exporters comparatively less attractive than their foreign competitors, further damaging the valuations of those companies.
No bid in a credit sell-off
“Corporate bonds remain a structurally illiquid asset class. In a sharp sell-off, there is a limit to how much investors could sell. Mutual funds and exchange-traded funds (ETFs) which have a high level of retail investors are of particular concern.”
This is a slightly more technical point, but in a nutshell it boils down to the idea that there is a finite level of demand for corporate bonds, and this could precipitate a liquidity crisis in the capital markets. In what would be roughly equivalent to a bank run scenario, investors would realize that there is a strong incentive in being the first to pull their money in a downturn. This first mover advantage could make the sell-off far worse as investors race to redeem their investments.
Fixed income: volatility comes back?
“Central banks’ actions and the private sector’s yield enhancement strategies have kept interest rate volatility subdued. With global reserves flow shrinking, there is a risk the trend may change."
Increased volatility in the bond market (due to central banks reverting to more conventional monetary policies) would have a knock-on effect on the equity market. In particular, capital could retreat from high-risk, high-reward companies as investors seek to park their money in more secure holdings.
Overall, what HSBC is most concerned about is potentially disruptive developments in the fixed-income space. While the capital market can be a more challenging to navigate and understand than the stock market, it pays to keep an eye on it.
(This article was co-authored by Stepan Lavrouk, director of research at Atreides Capital LLC and a former research analyst for Almington Capital Merchant Bankers.)
Disclosure: No positions.
