A relief rally in risk assets seen in 2019 to date will continue through the year amid continued support from central banks, a plethora of cash sitting on the sidelines and a “Trump put” on equity markets, according to Nomura Asset Management’s Dickie Hodges.
Hodges, who runs the Nomura Global Dynamic Bond fund, says the world suffered “a margin call on the cost of financing” in 2018 after leveraging up at the start of the year.
In December 2017, the US yield curve was pricing in around one interest rate rise in 2018. As a result, investors around the world geared up in the region of three to five times at a nominal rate of 1.25% and rushed into risky assets yielding 6-7% to find an income level sufficient for their needs.
In the end, the US Federal Reserve hiked rates four times. The Fed Funds Rate effectively doubled during the course of the year to a range of 2.25-2.5% with many investment banks pencilling in three or four further rises in 2019, which would have taken borrowing costs to 3-3.25%.
“[Investors] borrowed at the low level, then found it very difficult to sell the asset classes that they’d locked themselves into,” explains Hodges. “They held an asset, borrowed three-to-five times leveraged at 1.25% and the cost of leverage doubled.
“Essentially, the world had a margin call on the cost of financing. That means they needed to sell the asset they bought to pay for the margin on their cost of financing.”
At the same time, global central banks continued to withdraw liquidity from markets, lessening demand even further. “You came from a virtuous circle in 2017 into a vicious circle,” says Hodges. “It was almost a perfect storm for risk assets.”
So, it’s no wonder markets sold off in the third quarter of 2018 so dramatically. However, the relief rally year to date has been just as dramatic – if not quite wiping out October to December’s losses just yet.
That’s largely because of the Fed’s dovish turn in January. The Federal Open Market Committee’s most recent minutes revealed its previous rhetoric of “further gradual increases” in rates has now changed to “future adjustments”.
For some, this not only suggests rates will rise no more – indeed, futures markets are pricing in zero rate rises in 2019 – but that the next move could be a cut. Its quantitative tightening should end at some point later in the year, too. The Fed meets this week and is widely expected to hold interest rates.
Equity Rally Has Further to Go
Elsewhere, the European Central Bank “did almost a complete 180-degree turn on their expectations for growth and inflation”, Hodges says. It said rates would remain at present levels “at least through the end of 2019”, rather than the previous target of “at least through the summer of 2019”. Further, the Bank of England remains on hold until Brexit uncertainty clears.
Outside of the Western world, the People’s Bank of China has injected a “staggering” amount of liquidity into the market in order to sustain an economic growth rate between 6-6.5%. “Subsequent to that we have had them come out and suggest they will do all they can to prevent a financial crisis,” recalls Hodges.
So, the fact that interest rates aren’t going up anywhere any time soon has seen risk assets, particularly equity markets, rally in 2019 thus far. But they’re still way off the highs hit during the previous 12-month period.
Hodges uses the Euro Stoxx Bank index, which is made up of the 26 largest banking institutions on the Continent, to illustrate its point, as banks are the most sensitive companies to interest rate gyrations.
The index began 2018 at 131 before peaking at a two-and-a-half-year high 143 in late January. Through the course of the year, though, the index slumped to a two-and-a-half-year low of 85 by Christmas. “The market eroded nearly 50% of the equity valuation of the top European banks,” says Hodges.
“We’ve almost got to the point now where, unambiguously, global central banks have proved, shown and heard in their rhetoric that they will be supportive to capital markets. So, it’s hardly surprising that in the first two months of the year you’ve seen circa double-digit returns in valuations.”
It’s key to remember, though, that we’re still significantly below where we were even in September 2018. The, the Euro Stoxx Bank Index was at 112. Today, we’re still below 100.
With that said, Hodges outlines a trio of factors that should conspire to lift equity markets even higher throughout the remainder of 2019 – and potentially further.
Central Bank Support
The manager, who made his name at L&G, says the current environment reminds him of the collapse of financial markets in the wake of Lehman Brothers’ failing in 2008. We saw significant positive returns through to the start of 2016 as central banks held interest rates at or near zero.
Subsequent to the Fed raising rates for the first time post the financial crisis in December 2015, asset classes fell up to 20% before recovering those losses.
“It’s my view, therefore, that it has very little to do with economics; the path of growth. It has more to do with central banks have little choice but to be more supportive to capital markets than less so.”
The reason for this, he suggests, is fairly common sense: “When a company’s equity valuation drops by 10-15%, economies don’t grow; they contract because companies don’t hire, companies don’t pay, companies slow down any capex intentions or push it forward into the future.
“Central banks are not stupid and certainly the rhetoric that I have heard since the beginning of this year would indicate that they fully get it.”
Cash on the Sidelines
A recent survey of global fund managers carried out by Bank of America Merrill Lynch shows the number of professional investors “overweight cash” is at the highest level since January 2009. That comes as no surprise to Hodges. In fact, he says it gives him confidence.
He notes that cash balances tend to go up after market dislocations. It happened in 2009, then again in 2013 after the US taper tantrum and again in March 2016 after the oil price collapse.
“We’ve got a lot of under-invested assets, or cash, that is still looking for a level of income that meets investors’ expectations,” says Hodges. True, some of it has been drip-fed into markets in 2019 – “that’s where you’ve got the [year-to-date] bounce from”.
But US investors can currently gain 2.5% from cash, so they’re in no rush to invest their balance all in one go.
Still, you could soon see evidence of cash being invested soon, which should be supportive of markets as valuations are still cheaper than they have been for a while, and volatility is back to subdued levels, at around 16% as measured by the VIX Index as opposed to the fourth quarter’s 35%.
The third and final potential leg up for stock markets is what Hodges dubs “the Trump put”. While many are pinning their hopes on a trade deal between the US and China being agreed within the next month or so, Hodges sees no real benefit to US President Donald Trump, assuming he will be running for re-election next year.
What would make more sense for Trump’s re-election campaign is for an agreement to come later on in 2019, at the beginning of the fourth quarter, say. That’s because if markets follow the assumed path, they rise significantly on news of a deal.
Hodges explains: “If Trump were to come to some sort of agreement towards the end of the year and the reaction function is a subsequent rally in equity markets, he secures easily a double-digit return for US holders of a 401K [pension plan] going into the year-end.”
Further, while equity markets should re-rate immediately after a deal is agreed, it will take a period of time before the end to uncertainty filters through into the domestic US economy. That should happen just as we enter the election period, at the same time 2019’s weaker data starts to drop out of GDP calculations.
“You could potentially see a stronger bounce in economic activity going into the last three to four months prior to his re-election. That gives him a much greater probability of being re-elected,” predicts Hodges.
That said, he adds a caveat that he “could be very wrong” in assuming Trump even wants to run for a second term in the White House. One wouldn’t bet against it, though.