Cutting back on costs can lead to a challenging environment for risk assets
TINA, meaning “there is no alternative” to owning risk assets like credit and equities, has defined much of the current bull market. TINA wasn’t an accident, central banks purposefully sought to reduce the return available on safe assets to force investors into riskier investments, to lower borrowing costs and boost asset prices to support the economy.
While they achieved their goals, central bank actions also had unintended consequences. First, the rise in the value of financial assets – which are disproportionately held by the better-off – has contributed to wealth inequality. Some might argue that this inequality could be a factor behind some of the global political uncertainty that investors are currently contending with.
Second, while some housing markets corrected steeply, loose monetary policy allowed housing markets in some other parts of the world to rise to extended levels. Yet the biggest unintended consequence was that by keeping policy so loose for so long and pumping so much new money into the system, while they allowed the household sector in several key economies to reduce debt-to-GDP ratios, they also enabled corporates and governments around the world to increase their debt-to-GDP ratios.
The corporate leveraged loan market, for example, has seen a significant rise in leverage and a deterioration in covenant quality. Some auto loans have also gone to sub-prime borrowers. Neither of these markets are anywhere near as big as the mortgage market and most of the loans are not held by banks, so the risk to the banking system is much lower than in 2008 but investors who hold the lower quality versions of these loans should consider the risks involved.
Companies with investment-grade ratings have also increased their debt levels. Companies have taken advantage of cheap debt to buy other companies and to buy back their own shares, increasing debt-to-equity ratios. The risk is that as companies face rising wage costs and rising interest costs, as they refinance their debts, they might find themselves having to cut back on other costs. It’s the process of cutting back on costs that can lead to recessions and a more challenging environment for risk assets. Fewer share buybacks or reduced merger and acquisition activity could reduce the upward pressure on stock prices in coming years.
There is a risk that companies could also start to cut back spending on marketing, business investment and reduce headcount in an attempt to sustain their profits and avoid being downgraded. A more patient US Federal Reserve combined with Chinese policy stimulus will be needed to underpin corporate behaviour that supports growth.
Against this late cycle backdrop, investors might benefit from focusing on higher quality assets in the riskier part of their portfolios. For example, passive investments in credit indices – which favour the most indebted companies – could carry risks at this stage in the cycle. Likewise, equity investors might want to look for large, cheap, quality companies, which are the least vulnerable to the next downturn.
Today, TINA’s time is up, and there are now several viable alternatives available to investors to help them build a more balanced and diversified portfolio. US Treasuries, for example, look more attractive than they did a few years ago, when yields were much lower. US interest rates are probably more likely to be cut in the next few years than rise significantly further from here.
Even for non-US dollar investors, hedged medium- to long-dated Treasuries offer upside if US interest rates are cut during the next downturn. Most other major developed market government bonds offer less attractive yields and less room for rates to fall. While many emerging market government bonds offer high yields, some could be vulnerable if global growth deteriorates.
Beyond US Treasuries, the most attractive alternatives to risk assets can be found among the aptly named “alternative” strategies. In particular, those alternatives with a low correlation to risk assets look attractive at this late stage in the cycle.
Investors may therefore want to consider strategies such as global macro funds, some equity long/short funds and market-neutral funds, as well as defensive real assets like direct infrastructure investments, as some ways to add some balance to the riskier parts of their portfolios.
Mike Bell is global market strategist at JP Morgan Asset Management