It’s not often that you get not one, but two, of the most highly regarded and successful investment managers urging investors to beware the ongoing stampede in global equity markets.
But as asset prices across the board – equities, properties, low-grade corporate debt –have continued their surge, top executives from the world’s biggest hedge fund, Bridgewater Associates, and from leading alternative asset management firm Oaktree Capital have both sounded a note of caution.
Bridgewater’s co-chief investment officer, Greg Jensen, who helps manage some $US160 billion ($232 billion) in assets, gave a good explanation for the ferocity of the global share market rally in an interview with the Financial Times last week.
“There will no longer be an attempt by any of the developed world’s major central banks to normalise interest rates,” he said. “That’s a big deal.”
He added that Bridgewater was “more cautious” on US stocks which were seen as “frothy”.
Not a good time
Howard Marks, the co-founder of Oaktree Capital, which manages more than $US120 billion, was even blunter. When he was asked last week in an interview on Bloomberg Television whether now was a good time to be investing, he replied: “It is not.”
He went on to explain: “The market’s been up for 11 years, it’s quadrupled off the low. We’re in the longest bull market, the longest expansion in history.
“Profits are not rising, stock prices are. It’s what we call a liquidity-driven rally – that means it comes from people having a lot of money to spend. “
Marks said that “it doesn’t mean that the market’s going to go down tomorrow. But it does mean that the odds are not, in my opinion, in the investor’s favour.”
While these warnings might be eminently sensible, they’re bound to be ignored by the overwhelming majority of the world’s asset managers.
These individuals are under such pressure to match the short-term investment performance achieved by their competitors that they simply can’t afford to pull out of the race.
By contrast, Bridgewater and Oaktree have the luxury of long-established investment track records.
There’s another reason that most asset managers are joining in the frantic share market rally. They’re convinced that the US Federal Reserve is now in a position where it has to ensure the survival of even the riskiest, most debt-laden financial institutions.
But the US central bank abruptly changed tack in 2019. It cut US rates three times, and, instead of reducing its balance sheet, the Fed grew it more in the last four months of 2019 than at any comparable period since the global financial crisis.
What was particularly cheering for investors was that the Fed’s embarrassing U-turn wasn’t triggered by slowing economic activity or a sharp decline in inflation.
Instead, the Fed was forced to realise that years of ultra-easy monetary policy had encouraged an unprecedented level of risk-taking – primarily through the accumulation of much higher leverage – in global markets.
And unless this situation was handled extremely gingerly, global financial markets could again be at risk of seizing up.
In this respect, the near-disaster at Nasdaq Clearing, the outpost of the American stock exchange company in Stockholm, was a foretaste.
In September 2018, one individual trader – Einar Aas, who had once been one of Norway’s richest people – suffered heavy losses as his bets on energy prices went badly awry, leaving a shortfall of more than $US100 million.
Although the crisis was eventually contained, the losses depleted Nasdaq Clearing’s capital and nearly exhausted its emergency default fund.
It would be easy to dismiss the Stockholm near-crisis as the fault of a reckless individual.
Except that the similar problem played out a year later in the highly sophisticated US repurchase agreement (repo) market, where borrowers such as banks and hedge funds are able to borrow cash overnight by pledging high quality securities such as US Treasuries as collateral.
As you’d expect, life in the $US5.1 trillion repo market is typically pretty sedate. But there was a furious scramble for cash last September, particularly from lightly regulated and highly leveraged hedge funds.
Hedge funds had a big appetite for Treasury repos to fund a popular strategy, which involved them buying short-term US government bonds, while selling interest rate futures, and pocketing the difference in price. To make this a worthwhile trade, they had to leverage their trade with huge quantities of debt.
At the same time, major US banks – which are important lenders in the market – pulled back from lending to the market, preferring instead to keep any surplus funds on deposit with the US Federal Reserve.
Major US banks also play another critical role in the repo market, acting as a middleman for borrowers and lenders through a process known as a sponsored repo. The bank pairs hedge funds, which have to post US Treasuries as security, with money market funds that are willing to lend cash.
These transactions are cleared by the Fixed Income Clearing Corporation (FICC), with the bank taking on the credit risk that both sides of the deal will fulfill their obligations – repaying the cash or returning the securities.
When the repo rate climbed as high as 10 per cent last September – threatening not only to inflict searing losses on highly leveraged hedge funds, but also the banks that had back-stopped their trades – the Fed was forced to intervene. It pumped hundreds of billions of dollars into the repo market to keep a lid on short-term borrowing costs.
Not surprisingly, this huge injection of liquidity fuelled the powerful rally in global equity markets that’s now underway.
But now the Fed faces a dilemma. It wants to reduce the amount of liquidity it is pumping into the repo market, while still ensuring that hedge funds are able to meet their borrowing requirements.
One possible solution Fed officials are looking at involves lending to hedge funds directly through the FICC.
This would leave the Fed open to the accusation that it has extended its mandate to the extent that it is no longer just responsible for bailing out banks, but also has to make sure that risky hedge funds aren’t in any danger.
The Fed’s only alternative, however, is to continue to supply copious amounts of liquidity to the large banks, in the hope that enough of this will trickle through to the hedge funds.
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