A credit crisis is looming that threatens to wreak financial havoc, even as international markets continue to overlook a crucial mismatch in the US economy, warns Matt Murphy of US fund house Eaton Vance.
The institutional portfolio manager argues there is significant risk of US consumer price deflation and recession amid a widespread misunderstanding of both Federal Reserve action and the strength of America’s recovery.
Murphy was covering risks and opportunities he sees while speaking at AsianInvestor’s recent Japan Institutional Investment Forum in Tokyo (click here for photos). The event had earlier heard industry figures voice fears over stagflation in Japan.
Speaking to a room full of Japanese asset owners – chiefly pension funds – Murphy accused the Fed of mistakes in making its forward guidance dependent on unemployment data. “The unemployment statistic in the US is no longer a good barometer of economic policy,” he argues.
US economic indicators such as temporary help services and the fact that firms are able to fill job openings seem positive, he notes. But scratch below the surface and a mismatch can be seen between the skills employees have and those that employers are looking for.
Murphy points out that the Patient Protection and Affordable Care Act signed into law by US president Barack Obama in March 2010, known as Obamacare, incentivises businesses to hire people for part-time, not full-time, work.
If people work for more than 30 hours a week, they are entitled to around a 40% increase in wage costs, meaning in practice that more and more people are working 29.5 hours per week. This is reflected mostly in lower-income services jobs.
So while the unemployment rate has been falling, it has been driven by part-time hiring that is likely more structural than cyclical. The Fed is focusing on the utilisation rate – or the level of slack in the US labour market – as it gauges economic and financial conditions to determine monetary policy. It is this slack that leads Murphy to conclude that the Fed is further from a rate hike than the market is pricing in.
“So I look at the federal funds futures curve today, pricing in a rate hike in the US sometime in March 2015 [subsequently May 2015], and I think that is highly unlikely,” he says. “It will be a long time before the US hikes its rates.”
He moves on to express grave concerns about the US corporate credit market, with the Fed’s large-scale asset-purchasing programme having effectively driven credit spreads to very tight levels amid the widespread search for yield.
“During quantitative easing, pensions and insurance companies have no choice but to own corporate credit because financial repression forces them to own something that will offer them a real return,” Murphy says.
However, when the expectation is that large-scale asset purchases will end, these institutions start to sell while US retail mutual fund owners continue to pour into this asset class.
“Throughout the history of investing, institutions are the first ones in, they capture all the gains, and they are the first ones out," he says. "Retail chases that return and then gets stuck.”
Lack of liquidity in the US corporate credit market – driven by regulations such as Dodd-Frank, which eliminated proprietary trading at investment banks – is what keeps Murphy awake at night.
It is US retail mutual fund investors that have stepped into this breach as holders of US credit. And because they are essentially able to get their money back in a day, this leaves some serious financial instability issues, he says.
“If there is any run for the exits and they have to sell, they are forced to sell to someone else on the buyside that knows exactly that they are a forced seller. This is exactly what got the US in trouble in 2007.”
“So be wary of the cost of large-scale asset purchases, and also be wary of fact that no one is being compensated for liquidity premiums today in corporate credit.”
Murhpy warns, too, that not only is there a real risk of asset price deflation in the US, but also consumer price deflation. “Going back to the fact that there is so much slack in the US labour economy without the ability to raise wages, consumer price deflation is a serious risk."
He notes that US corporations are due to roll over their debt roughly four years from now. “It’s unlikely the US is not going to suffer a recession in the next four years, so it [corporate credit] is pricing as if there is not going to be a recession, and that is a concern.”
“Our disaster scenario is that a run for the exits in the US mutual fund industry becomes even more regulated after the fact.”
He said the easiest way for the Japanese pension funds in the room to hedge their portfolios was to buy short credit positions and credit default swaps.
“If there is any movement towards the exits by US retail mutual fund investors," he adds, "because that exit is so small, the price movement that we saw during the credit crisis of 2007 should be magnified."