vk.com/id446425943
MULTI-ASSET ● GLOBAL 11 December 2018
Kevin Logan
Chief US Economist
HSBC Securities (USA) Inc. kevin.r.logan@us.hsbc.com +1 212 525 3195
Edward Marrinan
Head of Credit Strategy, North America
HSBC Securities (USA) Inc. edward.b.marrinan@us.hsbc.com +1 212 525 4436
Nicholas Smithie
Senior GEMs Multi-Asset Strategist
HSBC Securities (USA) Inc. nicholas.d.smithie@us.hsbc.com +1 212 525 5350
Lawrence Dyer
Head of US Rates Strategy
HSBC Securities (USA) Inc. lawrence.j.dyer@us.hsbc.com +1 212 525 0924
The Fed keeps hiking
We expect three more Fed hikes until June 2019…
…but there is a risk that core inflation could accelerate and the Phillips Curve steepen, leading to further hikes
We think UST2y and US credit would be under pressure
Fed tightens beyond current expected levels
Fed policy changes in 2019 are likely to be more "data dependent". We expect three more hikes in the current cycle: December 2018, March 2019, and June 2019. While lower than anticipated job growth and inflation could lead to fewer rate hikes than the FOMC's current median projection of three 25bp rate increases, stronger growth and higher-than-projected inflation could lead to a faster pace of policy tightening than currently anticipated by financial markets.
Core inflation could accelerate in 2019
Core PCE inflation has already moved up from 1.5% in Q3 2017 to 2.0% in Q3 2018. Upward pressure on inflation is increasing as the labour market tightens. Over the same four-quarter period, the unemployment rate fell from 4.3% to 3.8%, putting it well below most estimates of the non-inflationary unemployment rate. If monthly job gains continue at the roughly 200,000 average of the past year, the unemployment rate will likely drop close to 3.2% by Q3 2019.
Phillips Curve steepens
While the US Phillips Curve has been "flat" in recent years, there is a risk that it could turn much steeper at current low levels of unemployment. In addition to labour market pressure, the possibility of higher tariffs on imported goods also raises the risk for higher inflation in 2019. Though planned tariff increases were postponed at the G20 summit in November, a tariff increase from 10% to 25% on USD200bn of imports from China is still possible in 2019 and tariffs on an additional USD267bn goods imported from China are also being contemplated.
If core inflation were to accelerate above 2.5% by the middle of 2019, the FOMC may feel compelled to raise the federal funds rate higher than the Committee's current median 3.125% projection for the end of 2019.
Investment implications
A more aggressive Fed tightening path would likely see the USD higher
The market already has a lower trajectory priced in for the US policy rate during 2019 than is embedded in the Fed’s dots projections. Were the Fed to deliver even more than the dots imply, then the boost to the USD could be sizeable. The US-centric nature of the catalysts for a more aggressive Fed (a steeper US Phillips Curve, higher tariffs on goods imported into the US) suggest the impact would be USD-centric as other central banks would likely not match the Fed’s hikes.
USD strength might be most acutely felt in sections of EM FX and higher beta G10 FX plays. Unexpectedly higher USD funding costs and a buoyant USD would resurrect the pressures
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evident during parts of 2018 in EM FX, although weaker currencies and higher interest rates might provide greater insulation this time around. The scale of reaction would also partly hinge on how much of the upside surprise in Fed tightening was prompted by higher US growth and inflation. Within G10, a more aggressive Fed would imply a more pronounced acceleration of the USD bull trend evident since May 2018, with likely gains concentrated against the EUR and high beta plays such as AUD, NZD and SEK.
US front end of the yield curve would shift up significantly
Long-term US rates would move to the upper end of their recent ranges on a faster hiking pace by the Fed. For 10-year yields, this is the 3.25% area. This view assumes that longer-term rate expectations remain well anchored. We see that as the likely outcome given our analysis of the risk of higher or lower medians for the FOMC’s dot plot, dealers’ and investors’ projected distributions of the Fed funds rate in 2020, and the historical stickiness of the 5Y5Y Treasury forward rate versus the expected peak rate.
Yields in the front end of the yield curve would shift up significantly, if the Fed hikes to 3.125% or more at the end of 2019. The Fed funds futures market projects a 2.72% rate (4 December). So, a higher 2019 funds rate and expectations of a higher peak funds rate would likely shift the two-year Treasury yield up by 40bp or more from its current 2.82% level.
USD Credit under pressure
If the Fed were to raise interest rates beyond our expectations, USD credit spreads would likely come under additional pressure. The associated tightening in financial market conditions would exacerbate the risks associated with the US corporate sector’s heavily leveraged balance sheet.
They are already being stressed by rising borrowing costs and credit rating downgrades resulting from late cycle behaviours, including aggressive share buybacks, high dividend payouts and a surge in large-cap, debt-financed M&A, among others.
Given our expectations that US GDP and corporate earnings growth will moderate in 2019, it is likely that the US corporate sector’s financial flexibility will remain compromised, absent a concerted effort to reduce leverage.
US equities and defensives to outperform
The outlook for US equities would depend on the growth backdrop in this scenario. If higher inflation is driven by stronger growth then equities could rise given that valuations have already derated significantly. But 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.
A tough scenario for emerging markets which favours EXD
Under this scenario, the EMBI spread which has widened by 114 bps, to 425 bps since the start of the year would probably come under further strain. As EM central banks would probably have to mirror the Federal Reserve, thereby extending the tightening cycle, we could see EM External Debt outperforming Local Debt in 2019 (see Through the Kaleidoscope, 29th November 2018).
This would lead to higher funding costs and investors would be likely to demand a higher risk premium, pushing the GBI-EM LCD yield back above the EMBI EXD yield. This would benefit investments where carry is available without taking duration risk.
An increase of more than 75 bps in the risk free rate would cause further compression of EM equity valuations. The 12-month forward PE multiple peaked at 14 times at the end of 2017 and has contracted to just over 11 times as of November 2018. The valuation could be further depressed to 10 times forward earnings, as was the case in 2011 – 2012.
Overall we would expect EXD to outperform in this scenario, supported by a relatively high yield, low volatility and insulation from EM currency depreciation.
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Dominic Kini
Analyst, Quantitative Credit Strategy
HSBC Bank plc dominic.kini@hsbcib.com +44 20 7991 5599
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 tend to have a high level of retail investors are of particular concern
What if there was a liquidity crisis?
In Credit Telegram: Eight questions about corporate bond liquidity (15 November 2018) we looked at weekly bond level volume data for corporate bonds. We saw that while corporate bond liquidity generally declines as the year progresses, with dips in April and August, a pick-up in October and November, and a sharp drop in December, the pattern from year to year has been remarkably stable (chart 1). And this despite the spread widening we have seen this year, and despite new pre-trade and post trade transparency requirements introduced by MiFID II/MiFIR on 3 January 2018.
1. EUR IG weekly bond volumes: Holding up, for now
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Source: HSBC calculations, TRAX, Markit. EUR IG = iBoxx EUR Corporates bond index.
But corporate bonds remain a structurally illiquid asset class. In particular:
10% of bonds account for just under half of traded volumes and 20% of bonds account for about two-thirds of volumes. This appears to be constant across time and markets
Most corporate bonds don’t actually trade every week. In the first 44 weeks of 2018, only
13% of EUR IG bonds and 25% of EUR HY bonds traded at least once a week
Liquidity is strongly skewed towards recent issues, with bonds issued less than a year ago accounting for 34% of volumes for EUR IG and 41% for EUR HY
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MULTI-ASSET ● GLOBAL 11 December 2018
Investment implications
In a sharp sell-off, it follows that there would be limit to how much investors could sell – and after all, there has to be a buyer for every bond sold. Of particular concern are mutual funds and Exchange Traded Funds (ETFs) which tend to have a high level of retail investors.
In Who owns what in 2018? (16 May 2018) we estimated that retail funds and ETFs make up some 24% of GBP credit assets, 10% of EUR credit assets and 16% of USD credit assets. Even if institutional money tends to be stickier, large outflows by retail could significantly move prices.
The concern is that, just as banks engage in maturity transformation, mutual funds and ETFs engage in liquidity transformation. This was evident, for example, in the collapse of Third Avenue’s Focused Credit Fund in December 2015 (Financial Times, 11 December 2015), which with only 10% of the assets BB or B rated, was much more a distressed fund than a high yield fund and arguably should not have been offering daily liquidity against these assets (Liquidity in a world of negative rates, 7 March 2016).
Even if investors understand that they do not benefit from deposit insurance and are subject to floating net asset value (NAV), given that mutual funds offer daily liquidity there is an incentive to be first to redeem in a market downturn. And even if a fund holds a portion of liquid assets, as a fund sells liquid holdings, the portfolio gets more illiquid, subjecting the remaining investors to time subordination.
There are, however, a few things which may temper the risk.
Swing pricing allows a fund to adjust its NAV by a swing factor – upwards, if there is a net inflow; downwards, if there is a net outflow. The adjusted NAV is the single price at which investors can buy or sell shares of the fund. But swing pricing does not apply to investors who are not transacting on that day, pushing the costs of trading onto investors who are trading. This is common in Europe – mandatory in the Netherlands – and optional in the US, subject to a cap of 2% of NAV
When investors sell an ETF, this is typically to another end investor and does not in itself result in outflows from the ETF. Rather, the ETF will trade at a discount to the NAV. The ETF manager only transacts with Authorised Participants – typically banks – who have the right to buy shares from investors and redeem those shares with the ETF manager in return for underlying assets (if those assets are trading at a premium to the shares), or deliver assets to the ETF manager in return for new shares (if those assets are trading at a discount to the shares). This keeps the NAV in line with the share price. But in the case of a sharp downturn in the price of the ETF, Authorised Participants have no obligation to buy shares and redeem them, potentially reducing the risk of a fire sale of underlying assets
The SEC has adopted new rules requiring mutual funds and open-end ETFs in the US to have a liquidity risk management programme in place by December 2018 or June 2019, including liquidity risk assessments and classifications and a minimum threshold for highly liquid investments. There will be increased disclosure of the liquidity position of funds, in detail to the SEC and in summary to the public, and reporting should a fund breach a maximum of 15% illiquid investments
But whether the above will be sufficient is untested. Many crises have their origins in some kind of mismatch: for example the duration of assets and liabilities in the UK insurer solvency crisis in 2002, assets and hedges in the Correlation Crisis in 2005, the maturity of Asset Backed Commercial Paper versus longer dated investments in 2007, or mortgages repayable in foreign currency (Woe the Swiss-Franc Mortgage on Non-Swiss Homes, Bloomberg 2 June 2017).
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