Jeremy Wharton, Church House joint CIO, delivers an informative assessment on the current state of global credit markets
As the year drew to a close, there was a mighty sense of relief on many fronts for markets. We begin our year of negotiation with the EU with Governor Carney saying the UK should avoid aligning our financial rules with the EU. His replacement elect, Andrew Bailey, comes from an institution that has arguably followed EU rules slavishly. We have the great relief that our country came to its senses and completely rejected the unpleasant and irresponsible policies of student union fanatics who have never grown up, but we remain in a long haul process. Still, the wet blanket of uncertainty has largely been removed (before the Election, the UK had its outlook cut to negative by Moody’s due to policy paralysis).
Optimism abounds that much can be achieved within the time available and that the UK economy can finally begin to return to its potential, especially in the face of a significant fiscal boost from government manifesto spending plans. The Debt Management Office has its work cut out issuing into the gilt market to fund these plans without destabilising the system, but we can take confidence from the fact that it is a well-run and respected institution. The MPC would be wise to refer to post election Economic data rather than data from a period when the country was collectively staring into a political and economic abyss.
We were wondering what the next catalyst might be to unsettle markets and then it was duly supplied by President Trump. The attack on General Qassem Suleimani, head of the Quds Force, the elite arm of the Islamic Revolutionary Guard, who seemed to have decided he was invulnerable, has, once again, destabilised the Middle East. The killing may have been justified but, as usual, the unilateral method of its execution left a lot to be desired (remember, though, that we are at the start of an election, and impeachment, year). Initial sharp, but contained, movements in crude oil prices, equity indices and credit spreads proved to be short-lived, although the situation is still developing and tanker rates have maintained their jump. We look in awe at US equity indices shrugging off any worries and again reaching new high levels, and feel a little queasy about it.
President Xi was upbeat and willing to negotiate an end/pause to the trade war, on the ‘basis of mutual respect and equality’, not Trump’s strongpoints. But, the US has its precious ‘Phase One’ trade deal now (a ‘big, beautiful monster’ according to Trump), although there is a long way to go. Most tariffs stay in place under this deal; its most direct effect is the cancellation of December 15’s scheduled tariffs on Chinese electronics and a halving of tariffs on $120bn of other imports. We still have 25% tariffs on $250bn of Chinese imports so ‘Phase Two’ is an important next step. There is a commitment from China to buy $200bn of US exports over the next two years.
As the year turned, liquidity measures from the Federal Reserve ensured we saw none of September’s spike in overnight money market rates.
The Federal Reserve remains on hold following three rate cuts, while signalling no change this year, and are becoming more optimistic about the US economy, especially after blow-out employment numbers. However, they remain in the firing line. President Trump appeared to reinstate tariffs on steel and aluminum from Argentina and Brazil out of spite for the Fed not furnishing him with negative rates. Like a jealous child, he remains envious of the Eurozone’s negative rates, but seems to be completely oblivious to the mess that they have produced.
New European Central Bank (ECB) President, Christine Lagarde, appears to be carrying on where her predecessor Mario Draghi left off. The ECB is ‘to continue bond purchases for as long as needed’. However, some in the ECB have been emboldened to express some division and to criticise some of Draghi’s parting (and previous) measures; in particular, the Netherlands pointed out that they have produced distortion of pricing in financial markets. He, and former Fed Chairman Yellen, took to the stage at the American Economic Association’s annual meeting to warn of policy mistakes in a low rate environment and stated that Central Banks don’t necessarily have the right tools at their disposal. With the German Government Bund curve still at negative yields out to ten years (‘distortion of pricing in financial markets’), the result of policies directly authorised and overseen by Draghi himself, this seems to turn the spotlight onto his strategy of wiring in the Eurozone financial system to an endless cycle of critical support. Weaning economies off dependence on Central Bank action in favour of individual government fiscal measures is surely wise.
Separately, the BoE stress tests showed our financial system could cope with a global crisis or a disorderly exit from the EU. All our biggest banks passed the 2019 test but the counter-cyclical buffer was raised to 2%. The report shows that under the worst case scenario, triggers of Lloyds and HSBC ‘bail in bonds’ would have been hit. They repeated that banks need to be ready for LIBOR ceasing to exist from 2021.
A dramatically busy burst of early-year bond issuance across all currencies into the primary market has given us one of the busiest starts ever, with €33bn, £5.5bn and $62bn in new issues in the first full week of the New Year. In sterling, we initially saw mainly financial (and floating rate) issues, many times oversubscribed. After issuance records tumbled in 2019, the supply of new sterling credit is likely to be lower this year as we have only £4.4bn of sterling bonds maturing in 2020 as opposed to the £13bn in 2019. The first to redeem is Heathrow Funding, where we would hope to see a rollover replacement. Credit spreads did nothing but rally over the fourth quarter and remain anchored at mid-2007 levels, reaching new five-year lows. This remains a cause of unease because we can all remember where they went from there. We won’t try and draw too many parallels with that period, but ultimately investors are not always being correctly compensated for the credit risk that they are embracing.
The above originally featured in our Winter 2019/20 Private Client Quarterly Review so is for information purposes only and does not constitute advice or a personal recommendation. The value of investments and the income you get from them may fall as well as rise and there is no certainty that you will get back the amount of your original investment. You should also be aware that past performance may not be a reliable guide to future performance.