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SMHNext correction will come from yield-hungry credit markets

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Mark Phillips

- The next market correction is likely to be driven by risky debt in credit markets, as investors seek higher yields from junk bonds, rather than issues within the equities market itself. - There is a global glut of funds seeking yield in risky corporate and sovereign debt, distorting prices. If there are defaults, it could cause liquidity issues and force selling of other assets. - While not expecting a crisis like the GFC, the chief expects a 10-20% correction from unsustainable valuations, driven by factors like rising US interest rates, though the long-term bull market may continue.

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Next correction will come from yield- hungry credit markets Date: August 29, 2014 Jeremy Chunn Risky debt: Junk bonds are being issued at record levels amid the market's never-ending hunt for higher yields. When the next correction comes it will look more like 1987 than 2007, and the culprit will be debt of a different kind. "Yes, there'll be another correction, but it won't be another global financial crisis," Millinium Capital Managers head of equities Neill Colledge says. "The causes probably won't come from inside the equities market." Shares are expensive, but not at levels which preceded the 1987 and 2007 drawdowns. The weakest link, he says, is the global credit markets. Precisely the place the global glut of funds has sought out yield as central banks have held rates at near-zero levels. "People are desperate for any sort of yield, and when you're getting zero on US treasuries you've got to go out and find something interesting," Colledge says.
In October 1987, a quarter of the market value of the All Ordinaries index was lost in one day, whereas 2007 saw the beginning of the global financial crisis, a slow, grinding downturn which lasted 20 months. In Australia, the S&P/ASX200 benchmark is still 12 per cent lower than its peak seven years ago. Managers of sovereign bond funds have been buying without discrimination, Colledge says. Yes, they did well holding Ukrainian bonds and Greek bonds, but recently, African nations which have defaulted in the past few years, have been "getting away new issues of a billion or two because the demand is there". No bouncers at the door "People want the yield and they're not looking too closely at the risk," Colledge says. The same is happening in the corporate market, where issuance of junk bonds is "at unprecedented levels". Millinium chief investment officer Mark Phillips says exchange-traded funds that have been wading into the credit markets are distorting yields because "they have no credit surveillance". "You can get into them, if you're an issuer, and once you're in there, you're in," he says, agreeing with the metaphor of a nightclub with no-one on the door. "That's where we see the risk. The key is credit." Illiquid low-rated bonds can have a disproportionate effect on the capital value of a fixed- income fund when the market jumps to sell, Colledge says. "You get a default in a couple of the junk bonds in the US or Europe, the fund managers want to sell and, because these aren't very liquid to start with, they can't get out," he says. A manager who is facing redemptions will need to sell other assets higher up the ratings scale. Hence safer assets are degraded in value via an association with riskier assets which may not have been obvious to investors. Managers shift to cash Reassessment of risk moves quickly to equities markets and a negative loop manifests in a correction. "We're not saying this is a particular problem of the Australian markets," Colledge says. Managers are shifting to cash and shorting the index as a hedge against losses if the market drops, and Colledge cites George Soros's short position against the S&P500. "It's clearly a consideration in his mind that this could correct," Colledge says. Cash rates in the US will inevitably rise and all other rates will rise with them. "That's a surprise we know is out there," Colledge says, comparing the situation with a party where
everyone's having a grand old time with the full knowledge the fun will end at midnight ... but no-one's wearing a watch. "We all know this is going to end but we just don't know when." Bull markets typically have corrections between 10 and 20 per cent, he says, but if investors expect the next correction to look anything like the GFC, they are in for a shock. "That, I can assure you, is the last thing we are worried about," Colledge says. "We do not think the GFC is about to recur; we do not think there will be anything like the same problems or the same severity." Market overvalued in 1987 All the same, a correction of 20 per cent can inflict significant pain. In 1987, the All Ordinaries index lost 25 per cent value in one day. By November 11, it was half the level it had been in mid-September. "It was extremely painful; a lot of people got carved up, but you still had a long-run bull market around it," Colledge says, "and that's more what we think will happen this time around." Investors focus on recent history, he says. "They think that what just happened is very likely to happen again, and that's not usually the case." In 1987, the market was simply overvalued, having run up 40 per cent in the preceding year. Events driving corrections "That's totally unsustainable for a market whose the long-term return is about 11 per cent," Colledge says. "Forty per cent was clearly off in fairy land." Markets can stay overvalued for up to three years, so the lead-up to a correction is very like a Western where the revolvers are drawn and everyone's waiting for the dame's handkerchief to hit the ground. "Exogenous events tend to drive corrections," he says. In 2007, "the writing was on the wall" in July and August when the fixed interest market "began to come unstuck". Funds which could not meet redemptions were forced to shut down. Meanwhile, equities kept rising. "Obviously we weren't reading from the same song book here," Colledge says.

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SMHNext correction will come from yield-hungry credit markets

  • 1. Next correction will come from yield- hungry credit markets Date: August 29, 2014 Jeremy Chunn Risky debt: Junk bonds are being issued at record levels amid the market's never-ending hunt for higher yields. When the next correction comes it will look more like 1987 than 2007, and the culprit will be debt of a different kind. "Yes, there'll be another correction, but it won't be another global financial crisis," Millinium Capital Managers head of equities Neill Colledge says. "The causes probably won't come from inside the equities market." Shares are expensive, but not at levels which preceded the 1987 and 2007 drawdowns. The weakest link, he says, is the global credit markets. Precisely the place the global glut of funds has sought out yield as central banks have held rates at near-zero levels. "People are desperate for any sort of yield, and when you're getting zero on US treasuries you've got to go out and find something interesting," Colledge says.
  • 2. In October 1987, a quarter of the market value of the All Ordinaries index was lost in one day, whereas 2007 saw the beginning of the global financial crisis, a slow, grinding downturn which lasted 20 months. In Australia, the S&P/ASX200 benchmark is still 12 per cent lower than its peak seven years ago. Managers of sovereign bond funds have been buying without discrimination, Colledge says. Yes, they did well holding Ukrainian bonds and Greek bonds, but recently, African nations which have defaulted in the past few years, have been "getting away new issues of a billion or two because the demand is there". No bouncers at the door "People want the yield and they're not looking too closely at the risk," Colledge says. The same is happening in the corporate market, where issuance of junk bonds is "at unprecedented levels". Millinium chief investment officer Mark Phillips says exchange-traded funds that have been wading into the credit markets are distorting yields because "they have no credit surveillance". "You can get into them, if you're an issuer, and once you're in there, you're in," he says, agreeing with the metaphor of a nightclub with no-one on the door. "That's where we see the risk. The key is credit." Illiquid low-rated bonds can have a disproportionate effect on the capital value of a fixed- income fund when the market jumps to sell, Colledge says. "You get a default in a couple of the junk bonds in the US or Europe, the fund managers want to sell and, because these aren't very liquid to start with, they can't get out," he says. A manager who is facing redemptions will need to sell other assets higher up the ratings scale. Hence safer assets are degraded in value via an association with riskier assets which may not have been obvious to investors. Managers shift to cash Reassessment of risk moves quickly to equities markets and a negative loop manifests in a correction. "We're not saying this is a particular problem of the Australian markets," Colledge says. Managers are shifting to cash and shorting the index as a hedge against losses if the market drops, and Colledge cites George Soros's short position against the S&P500. "It's clearly a consideration in his mind that this could correct," Colledge says. Cash rates in the US will inevitably rise and all other rates will rise with them. "That's a surprise we know is out there," Colledge says, comparing the situation with a party where
  • 3. everyone's having a grand old time with the full knowledge the fun will end at midnight ... but no-one's wearing a watch. "We all know this is going to end but we just don't know when." Bull markets typically have corrections between 10 and 20 per cent, he says, but if investors expect the next correction to look anything like the GFC, they are in for a shock. "That, I can assure you, is the last thing we are worried about," Colledge says. "We do not think the GFC is about to recur; we do not think there will be anything like the same problems or the same severity." Market overvalued in 1987 All the same, a correction of 20 per cent can inflict significant pain. In 1987, the All Ordinaries index lost 25 per cent value in one day. By November 11, it was half the level it had been in mid-September. "It was extremely painful; a lot of people got carved up, but you still had a long-run bull market around it," Colledge says, "and that's more what we think will happen this time around." Investors focus on recent history, he says. "They think that what just happened is very likely to happen again, and that's not usually the case." In 1987, the market was simply overvalued, having run up 40 per cent in the preceding year. Events driving corrections "That's totally unsustainable for a market whose the long-term return is about 11 per cent," Colledge says. "Forty per cent was clearly off in fairy land." Markets can stay overvalued for up to three years, so the lead-up to a correction is very like a Western where the revolvers are drawn and everyone's waiting for the dame's handkerchief to hit the ground. "Exogenous events tend to drive corrections," he says. In 2007, "the writing was on the wall" in July and August when the fixed interest market "began to come unstuck". Funds which could not meet redemptions were forced to shut down. Meanwhile, equities kept rising. "Obviously we weren't reading from the same song book here," Colledge says.