A new bubble emerging in non-financial corporate debt could threaten global financial stability, according to Clark Fenton, Portfolio Manager, Diversified Returns at RWC Partners.
Ballooning debt, alongside slowing earnings and rock-bottom interest rates indicate there may be trouble ahead.
According to Fenton we are at the “Over-Extended Leverage” phase in the market cycle where both corporate and consumer debt is growing; asset valuations are high and defaults are ticking up.
The next stage of the cycle is de-leveraging, which usually comes after market shock, such as the financial crisis or bursting of the dot com bubble.
Fenton says: “As debt builds up, assets can do well but when debt reaches a peak and starts to turn over, asset prices tend to suffer – it’s a cycle that has repeated over time.”
While banks are in better shape than they were in 2008, Fenton is concerned that non-financial corporates have leveraged up significantly in recent years and could be the culprit in the next slowdown.
He adds: “Non-financial corporate debt to GDP is at an all-time high and higher than in the last crisis. This is where a potential bubble could blow up.”
And it’s not just the scale of debt that could cause problems, Fenton warns, it is the nature of it too. BBB-rated debt now accounts for a record proportion of the investment grade universe, a sign that as debt is increasing, the quality of the debt is deteriorating.
Fenton says: “From the end of 2008 when credit became lax because of extraordinary monetary policy, we’re at a point again where debt is too cheap and easy. When debt is this high, the slowdown doesn’t need to be that big to cause a problem.”
But investors shouldn’t fear all debt, he adds: “Growing debt is fine, as long as earnings and the ability to service the debt are growing at a similar rate. It’s when you get a divergence – which is what we’ve seen in the past several months – that problems may emerge.”
One cause for concern is how untroubled equity markets appear to be despite the signs of stress, says Fenton. The US stock market has hit another all-time high, but valuations are looking stretched.
Fenton says: “It shows how dependent the market is on easy financial conditions. There needs to be the continuation of these extraordinary measures by central banks just to keep the credit show on the road.”
Fenton has been positioning his portfolio defensively since mid-2018, with liquidity and capital preservation his key priorities.
In fixed income, he likes US treasuries, which should benefit as the Fed keeps interest rates lower for longer and strategies that will benefit from credit spreads widening.
In commodities he is positive on the prospects for gold, another beneficiary of central bank policy.
He adds: “A lot of central banks are trying to diversify their reserves away from the dollar and many have been buying gold.”
As the next stage of the cycle kicks in, Fenton is ready to take advantage of potential opportunities. He is considering equities that could benefit if inflation picks up, a risk he believes is underappreciated by the market.
“The idea of being defensive but not making money out of a crisis is not enough. We are looking to make money for our investors in periods of market drawdown,” he says, “We’re not a bear-market fund structurally, but we’re looking to make money out of the next bear market.”