Vancouver Sun

CENTRAL BANK SUNSHINE CAN’T LAST FOREVER

Bond yields have been pushed to record lows, writes Martin Pelletier.

- Martin Pelletier, CFA is a portfolio manager and OCIO at TriVest Wealth Counsel Ltd, a Calgarybas­ed private client and institutio­nal investment firm specializi­ng in discretion­ary risk-managed portfolios as well as investment audit and oversight services.

Many of us Albertans woke up the other day to our first sight of snow and frosted windows, a friendly reminder that winter is coming.

Coincident­ally, the market action this past Friday also sent a chill down many investors’ screens, suggesting that cold winds may be on the immediate horizon.

The problem is that this has become a market built around central bank sunshine.

Events like Brexit quickly turn into buy-the-dip opportunit­ies as the Bank of England, Bank of Japan, the European Central Bank and the Federal Reserve coordinate their actions to support the markets.

As a result, bond yields have been pushed to record lows as speculator­s position for capital gains on further interest rate drops and stocks have reached new highs on multiple expansion.

Of most concern is that this has caused investors to pile more risk into their portfolios by adding junk bonds and highly volatile commodity-related investment­s such as oil and emerging market stocks.

The U.S. high-yield corporate bond market, as measured by the iShares iBoxx $ High Yield Corporate Bond ETF, is up nearly 6.5 per cent this year excluding interest payments.

We find it interestin­g that there is little to no mention these days of the U.S. junk bond sector’s exposure to energy — which represents more than 13 per cent of the market — despite a recent Moody’s report indicating that there will be twice as many energy bankruptci­es in 2016 than there were last year.

Another example of irrational risk taking is in the energy sector itself, as investors having been buying oil stocks despite persistent­ly weak fundamenta­ls and a very soft oil price.

For example, to the close on Thursday, the Capped Energy Index was up 25 per cent year-todate compared to an oil price that is down 3.7 per cent.

Such a large disconnect between stocks and their underlying commodity is usually a very bearish warning sign. We are not alone, as some of the brightest oil company executives appear to be very aware of this situation and are all too happy to accept those bankers’ bought deals.

Moving on to emerging markets, investors are looking past concerns of slowing growth in these countries and instead focusing on the discount multiple they are trading at, relative to frothy markets like the U.S. As a result of all the buying this summer, the MSCI Emerging Market Index has rocketed up 30 per cent from its January lows and is up more than 18 per cent this year as of Thursday’s close.

What many forget is the inherent danger whenever a market trades away from fundamenta­ls and investors instead look to find high beta ways to torque their portfolios. We saw hints of this on Friday with the Capped Energy Index selling off nearly 3.1 per cent and the MSCI Emerging Market Index losing 3.5 per cent on the day.

Looking ahead and to add some further perspectiv­e on the downside risk potential, when the S&P 500 rolled over 13 per cent from its November 2015 highs to its February 2016 lows, the Capped Energy Index was crushed, dropping 31 per cent, while the MSCI Emerging market index lost nearly 21 per cent.

With all of the recent talk of a Federal Reserve rate hike being on the immediate horizon, this is not good news for such high beta plays. Oil, for example, will typically trade inversely to its dollar denominati­on and a Fed rate hike will raise the value of the U.S. dollar and lower the price of oil.

Additional­ly, market risk may have become even more sensitive to interest rates than many expected, given we’ve been on the morphine drip of ultralow interest rates for far too long.

Even a small 25 basis point increase could take the wind out of those markets driven purely by speculatio­n. With all these early signs of winter appearing on the immediate horizon, it may be time to consider taking some risk off the table: central banks, after all, can’t shine forever.

 ?? RICHARD DREW/THE ASSOCIATED PRESS ?? Much like the weather of late, stock market action this past Friday sent a chill down many investors’ screens, suggesting that cold winds may be on the immediate horizon. One of the main stumbling blocks centres around the fact that today’s market has...
RICHARD DREW/THE ASSOCIATED PRESS Much like the weather of late, stock market action this past Friday sent a chill down many investors’ screens, suggesting that cold winds may be on the immediate horizon. One of the main stumbling blocks centres around the fact that today’s market has...

Newspapers in English

Newspapers from Canada