Bridgewater Associates has roughly $160 billion under management, making it the largest hedge fund on the planet. Exchange traded funds like Vanguard FTSE Emerging Markets (VWO) the SPDR Gold Trust (GLD) and the S&P 500 SPDR Trust (SPY) head the list of top holdings.
Last week, Bridgewater said, “We are bearish on financial assets as the U.S. economy progresses toward the late cycle, liquidity has been removed, and the markets are pricing in a continuation of recent conditions despite the changing backdrop.” What are Bridgewater executives chiefly worried about? A market that is entirely reliant on higher duration bonds like the 10-year U.S. Treasury bond.
In particular, should bonds with longer maturities rise much more than they already have, scores of corporate borrowers would struggle to repay debts. Meanwhile, consumers would have difficulty gaining access to credit and/or qualifying for loans. According to Ray Dalio, founder of Bridgewater, the credit-dependent financial system would reprice assets significantly lower.
Could the world’s largest hedge fund be wrong? Certainly. On the flip side, the typical company is more leveraged today that at any time in recent memory. The sharp increase in debt at the corporate level means that companies are more vulnerable to rising borrowing costs, Federal Reserve policy error and/or a weakening global economy.
Making matters more tenuous, corporations have largely swapped equity for debt in the form of stock buybacks. Did this help the asset balloon inflate in the short-term? Without a doubt. At the same time, the process has rerouted capital away from more productive expenditures over the longer-term (e.g., research/development, employee training, computer networking, land, office, etc.).
Stock buybacks may be a tax-efficient way to return capital to shareholders. The process may or may not be a form of stock manipulation to drive up prices. (Note: Buybacks were illegal prior to 1982 because the Securities and Exchange Commission regarded them as manipulation.)
Yet the buyback frenzy that the tax cut windfall reignited will only benefit repatriated corporate cash from overseas once. Similarly, after 2018, year-over-year earnings comparisons will no loner benefit from the tax cut infusion. And that means the market will begin looking ahead to 2019’s prospects in the 2nd half of this year.
Over-leveraged corporations buying back shares in a stimulus-addicted world economy troubles the folks at Bridgewater. The hedge fund opined, “2019 is setting up to be a dangerous year, as the fiscal stimulus rolls off while the impact of the Fed’s tightening will be peaking,” and “…since asset markets lead the economy, for investors the danger is already here.“
Again, Ray Dalio and his team at Bridgewater could be off the mark. Maybe the Fed will stop tightening sooner. Perhaps higher borrowing costs will not adversely impact junk-rated corporate bonds. Perchance the global economic landscape will be vibrant for many years to come.
Or not. Projections by leading economists suggest that seven of the top 10 economies will be slowing in 2019. China, Japan and Germany are particularly troublesome, while Italy faces sovereign debt woes and Canada will be fending off a collapse in real estate.
Buy-n-hold advocates suggest that there is little reason to fret. Neither a domestic recession nor a global recession is imminent. Interest rates are still low on a historical basis. Buybacks will continue boosting earnings-per-share results as well as reduce the supply of stock available to a demanding global community. And in the worst scenario, central banks will simply move from tapering and tightening back to dramatic easing.
Of course, if things were quite this rosy, would prominent buy-n-hold proponent Warren Buffett still be holding $116 billion cash? That was at the end of 2017. What’s more, it represents an approximate cash position of 25% relative to market capitalization.
The big question here is why? When one of the world’s richest human beings and stock-picking legends suggests that others should always be 90% in Vanguard Total Stock Market (VTI) and 10% in Vanguard Total Bond Market (BND), why is Mr. Buffett having so much difficulty selecting companies to acquire outright or buy shares in?
It may or may not come as a shock to some folks, but Mr. Buffett actually provided the answer to this question in a recent report. He explained that one of the key qualities that he looks for is a sensible purchase price — “a requirement that proved to be a barrier to virtually all deals we reviewed in 2017.”
Think about it. Buffett has enough cash on hand to acquire 450 of the S&P 500 companies outright. He did not buy any of them. Nor did he reduce the cash position to expose himself to more shares of any S&P 500 components. He has chosen cash in the form of short-term Treasuries.
Is it conceivable that Mr. Buffett sees the same problem that Thomas Hoenig, vice chairman of the FDIC, described? Specifically, Mr. Hoenig identified that U.S. banks collectively returned 99% of net earnings to shareholders via buybacks and dividends.
Is it possible that Mr. Buffett does not want you to panic when the rising cost of credit reaches a “tipping point?” Indeed, he may actually share the same concern about Federal Reserve policy as Mr. Dalio of Bridgewater.
Today, June 13, the Fed raised its overnight lending rate to a range of 1.75%-2.0%. And the central bank anticipates two more hikes in 2018 alone. Perhaps the muted reaction by longer-dated bonds actually serves as a bit of relief for borrowers, as the 10-year yield only moved from 2.96% to 3.00%.
It is worth noting, though, that the yield curve is getting flatter by the day. There is a mere 40 basis point differential between 10s and 2s. And further out on the curve? 30s and 10s are moving towards 10 basis points. Can you imagine making a long-term buy-n-hold decision to lock in 3.09% for 30 years over 3.00% over 10 years?
Bottom line? The world’s largest hedge fund believes that stocks, high yield bonds and a variety of risk assets are heading for a fall. And they’re not talking about the reality that a bearish environment will occur someday; they expect the “fit to hit the shan” sooner rather than later.
In the same vein, revered experts like Warren Buffett have rarely had as much cash on the sidelines. He cannot identify a deal that he likes enough or shares of stock that he likes enough to shrink cash on Berkshire’s balance sheet.
Corporations using debt have never been as leveraged as they are right now. Absent buybacks and the corporate tax cut, profitability and revenue have been relatively stagnant. That’s the reason you get some of the most overvalued readings for valuations in history.
I am not implying that one run for the proverbial hills. I leave that decision for those who look to profit from shorting. Nevertheless, the extraordinary rise in corporate leverage alongside the decrease in credit quality will create another credit crisis. And junk bonds won’t be the only asset to get whacked.
You might benefit by forgoing questionable credit, even those with a tag of “investment grade.” Stick with shorter maturities and BBB+/A- or better.
As for equities, you might maintain your target allocation due to the technical uptrend. When the monthly close on the 10-month simple-moving average crosses below the trendline, though, it is sensible to reduce your exposure to stocks.
Disclosure Statement: ETF Expert is a web log (“blog”) that makes the world of ETFs easier to understand. Gary Gordon, MS, CFP is the president of Pacific Park Financial, Inc., a Registered Investment Adviser with the SEC. Gary Gordon, Pacific Park Financial, Inc., and/or its clients may hold positions in the ETFs, mutual funds, and/or any investment asset mentioned above. The commentary does not constitute individualized investment advice. The opinions offered herein are not personalized recommendations to buy, sell or hold securities. At times, issuers of exchange-traded products compensate Pacific Park Financial, Inc. or its subsidiaries for advertising at the ETF Expert website. ETF Expert content is created independently of any advertising relationship.