| The havoc created earlier this year in the us treasury market, which had its biggest single-day tumble in history, had little to do with the much-feared return of inflation. After all, notes James Bianco, research director at the institutional bond brokerage house Arbor Trading Group of Barrington, Illinois, there’s little economic logic in a market that dips by almost the same amount when the department of labor’s monthly employment number is 705,000 new jobs per month as when it is 150,000. That is precisely what happened in March, when t-bonds fell by a record-breaking three points, and again in April, when they dropped by a similar 2.25 points. More important than economic data, it seems, are the dominant movers and shakers in the market. Japanese investors bowing to government pressure, high-rolling hedge funds locking in arbitrage spreads and powerful central banks cementing international diplomacy, all have had a hand in the recent market turmoil. But another big player – largely ignored by professionals till now – is the one to watch going forward: the $3 trillion of us mutual funds investment. For decades these small-time individual investors played it safe in bank certificates of deposit or the fixed income markets, fearful of the risks in the stock market. Now, convinced of the superior returns of equities, they have been deserting the bond markets in record numbers ever since the 1994 rout. Last year they sold $42 billion worth. For the six months ended March 31 1996, only 9% of us mutual fund investment went into bonds and the rest went to the us stock market at the rate of about $20 billion a month, calculates Bianco. It is a sharp change from past peaks of mutual fund investment, when between a half and two-thirds of the total went into bonds. us stock market bulls have argued that a demographic shift caused by baby-boomers’ increased savings offers little cause for concern. But even though mutual fund assets will soon exceed the nation’s basic money supply and top the assets of commercial banks, Bianco argues that it isn’t new money. When the rise in market capitalization is factored in, the total savings haven’t grown that much, if at all. There is merely a shift among asset classes. “Nothing,” Bianco says, “is going into anything but stocks.” Ominous trend Bianco credits Jeremy Siegel, whose book Stocks for the Long Run made the New York Times bestseller list for months on end last year, for drumming into the public the truth that over time, stocks outperform bonds: “It’s starting to get into people’s heads that this thing is invincible, that it doesn’t ever go down.” He believes this is an ominous trend. Mutual funds now own 20% of the us stock market, up from 2% in 1982, and have sent it into a frothy mania seemingly impervious to reality. Even the mighty hedge funds dare not bet against them. “It’s a money-flow argument that is driving the market right now,” says Bianco. Indeed, the psychology at work is so powerful that it seems to have overwhelmed another driving market force: the us Federal Reserve. While equities climbed steadily over the past two years, fixed income markets have become even more volatile, almost totally at the whim of such speculative forces as hedge funds and investment banks’ trading floors. Even the Fed’s recent announcement that it was not likely to raise interest rates at its May meeting could not give the bond market much of a boost. At the same time, the stock market defied predictions by such renowned strategists as Morgan Stanley’s Byron Wien, who forecast that long bond yields above 7% would cause a major decline in the stock market averages. Declining by about 10% this year, the long bond has topped 7%, whereas only a momentary downturn in stocks has since been recouped. The Dow Jones Industrial Average was up 13% for the year towards the end of May. (Wien has revised his positon, saying he is bullish on the stock market, medium-term.) The mutual funds’ love-affair with us stocks has had far-reaching effects, even helping to reflate emerging markets euphoria. Coupled with low interest rates worldwide, “the tremendous boom on Wall Street has made people begin to worry whether it’s sustainable, and they’re starting to put their money elsewhere,” says John Armstrong, a partner at Independent Strategy in London. After last year’s Mexican crisis, investors became more discerning about individual emerging markets, but in recent months, Armstrong says, “there’s been a kind of indiscriminate rush”. After all, it’s hard to find a market that could beat the main us stock market average returns of 35% last year. Deutsche Morgan Grenfell’s Grant Kvaldheim in New York adds, “there’s a demand for yield”, and cites the strong interest in dm-denominated Latin American debt this year. According to the Washington-based International Institute of Finance (iif), emerging markets attracted $200 billion in private investment last year and are expected to attract a similar amount this year, with more coming from bond and equity portfolio investments. “Equity prices have rebounded, bond issues rose in the first quarter and spreads have narrowed,” says William Cline, deputy managing director and chief economist at the iif. Cline says the emerging markets would be receiving even more capital had a number of countries, such as China, Chile and Brazil, not instituted policies to limit foreign investment. Even in India, whose recent elections are viewed as a vote against economic reform, international investment had helped push the stock market up 20% by mid-May. A sure sign of changing sentiment is renewed hedge fund activity. Some of the bigger macro players have already left the emerging markets after a punt last year, but smaller ones are picking up the slack. Hedge funds that specialized in us equities sprouted up almost weekly last year, but since the end of 1995 emerging markets have been the single most popular category of hedge funds among investors, reports Tass Management, which tracks hedge funds. “We are seeing a lot of interest in emerging market funds and a lot of emerging market funds being established,” says Nicola Meadan, chief executive of Tass. Tass is in the process of adding 23 new emerging market hedge funds to its current database of 55 funds, which together have $3 billion under management. Pension funds are following close behind in the race to invest in emerging markets. Until recently, capital flows at work in the international markets may have obscured the mutual fund effect. Last year international fixed income markets – from us treasuries to emerging market bond issues – were driven primarily by the easy monetary policy of the Bank of Japan (boj) in conjunction with its intervention in currency markets. The latter move, an attempt to weaken the yen against the dollar, was part of an international accord hammered out between Japan and the United States. The after-effects of this global liquidity bubble are just starting to be felt. During 1995, notes Goldman Sachs partner and chief currency economist James O’Neill, the boj spent $50 billion buying us treasuries in an attempt to push the yen back above 100 to the dollar. That helped drive us bond yields lower, which gave an additional boost to the us stock market. “It’s the single biggest intervention by a central bank on a continuous basis that’s ever happened,” says O’Neill. “I am in the camp that believes that central banks have enormous power in financial markets. When they decide that trying to impact the value of their currency becomes their number one priority, to ignore what they’re trying to do is a bit crazy.” The boj had some help. Big Japanese investors, such as its mammoth insurance companies, were also pressured by the government to buy us treasuries. The boj’s monetary easing – an attempt to pull Japan out of a deflationary slump it had been mired in for years, along with the its commitment to a weak yen – was too much for hedge funds to resist. The combination turned into a no-lose proposition for the big guys, who turned their flailing fortunes around: shorting yen and investing the borrowed proceeds in us treasuries. This is known as the “yen carry trade”. It helped push the average returns for the macro hedge fund managers to over 30% last year, with Soros’ Quota fund up 160% after fees, according to Meadan. “A lot of it was driven by the yen/dollar trade,” she says. Neither the Japanese investors nor the hedge fund operators are in for the long haul, however. The chief investment officer of a big Japanese life insurer says his company has grudgingly given in to the pressure – but only for a short time. “They’re not here to stay,” says a source close to the insurance company. In fact, Japanese investors began selling their us securities in the fourth quarter of last year, according to chief economist Louis Crandall at rh Wrightson Associates, a bond market research firm in New York. That was the same time hedge funds engaged in massive buying. Their purchases kept the rally going until early 1996. According to the us treasury, Japanese private investors sold $14.5 billion of treasury notes and bonds during the fourth quarter of 1995, after buying $31.4 billion earlier during the year. Purchases of treasury coupons by tax haven investors, widely viewed as a proxy for hedge fund holdings, surged to $30 billion during the fourth quarter. Global bond markets began to quiver in February, shortly after the Japanese press quoted boj governor Yasuo Matsushita on the bank’s likelihood of raising rates in a recovery. Satisfied with the yen’s depreciation against the dollar, the boj had already stopped intervening in the currency markets. The central bank was also believed to be concerned about the huge impact hedge funds were having on their currency and interest rates, and wanted to get them out. Then a much-watched survey of Japanese corporate expectations of the economy was released, indicating a slight turnaround in the economy. “All of a sudden the markets became paranoid that the boj would raise rates,” says O’Neill. Fearful of a replay of the 1994 Fed interest rate hike that pummelled them, some hedge funds began unwinding their positions. On the back of nervousness about Japan came higher us employment figures than expected, and the bond market tanked, making its single biggest dip since 1974, the beginning of the long bear market in bonds during that inflation-wracked era. Japanese portents The debate over when Japan will raise interest rates has gripped the international bond markets all year. Many have argued that the banking system is still too frail for the boj to tighten, but some strategists and analysts are beginning to change their views. “I’ve spent a lot of time talking to Japan experts and the boj, and you can tell they think the worst is over and they want to move policy back to normal,” says Bluford Putnam, chief global strategist at Bankers Trust Investment Management Group. He is predicting that the boj will raise rates in July. That’s the judgment of the futures markets too, where three-month yen deposit rates, now at 0.5%, are projected to be at 1.25% by the end of the year. Another portent was last month’s hike in the prime lending rate by the Industrial Bank of Japan and other long-term credit banks. With rates in decline for most of a decade, most economists and market strategists realize it’s just a question of when Japanese rates will rise. Although recent comments from the boj indicated no rate rise is imminent, another corporate survey is due out in June, and if the boj were to decide after that to raise the discount rate, now at 0.5%, by even 25bp, the effect could be tremendous. “If they raise the discount rate, the impact is big,” says Yuichi Matsushita, market strategist at the Nikko Research Centre in Tokyo. Higher Japanese rates would likely affect the boom in yen-denominated securities in the international markets. For example, some 33% of all emerging market bond market issues were denominated in yen last year, more than twice the previous year’s 16%. “Many borrowers, including those in Latin America, who had raised funds mostly in the us market in previous years, took advantage of the low rates in the Euroyen and samurai markets in 1995, and the appetite of Japanese investors for higher yielding paper,” says the iif’s Cline. The trend has continued into 1996, but the hasty retreat from the us government securities market by Japanese investors late last year is an indication that other markets could also lose their appeal as Japanese investors find that the costs of financing their positions are rising. Many have already been raising cash. One immediate loser would probably be Japan’s stock market: the Nikkei 225 stock index has risen about 50% since last summer. Certainly a 25bp rate hike won’t hurt corporate profits or even destroy the huge spread banks need to rebuild their balance sheets. But it could undermine the stock market nonetheless, since its rebound over the past year was largely driven by foreign investors, including the big hedge funds that shifted out of emerging markets into the Japanese stock market, sensing an economic recovery in the making. “Even though the hedge funds are a tiny amount of the market, they have an impact,” says Eric Starr, a principal at Aventine Investment Management, a small New York-based hedge fund whose arbitrage strategies between Japanese warrants and the underlying securities earned it a 124% return in 1995. “They are the first ones to liquidate because of the leverage of the strategy. A small increase in rates could have a big impact on them.” (His strategy would not be hurt, he says.) To avoid potential yen problems, some hedge funds have switched to funding their us securities by shorting the Swiss franc, another overvalued currency, and even the German mark, a favoured target for those worried about the future of European monetary union. “There’s a strong sense that both the mark and the Swiss franc have been pushed to such giddy heights that it’s starting to do a lot of damage,” says Hunt Taylor, managing director of Finex Europe in Dublin, the European trading operation of the New York-based Cotton Exchange. In the same search for yield that has boosted emerging markets, investors have been flocking to the high-yielding currencies of Europe. “The volumes and the averages in both the customer and interbank market are higher this year than last,” says Guy Whittaker, head of global foreign exchange at Citibank in London. The winning currencies have been the Italian lira and the Swedish krona, with the Swedish bond market last year’s best performer. This year hedge funds have even been playing the French franc against the mark. While much of the action has shifted to Europe, not all hedge funds have been able to unwind their yen/dollar positions. No-one knows how large the business is, but traders estimate that as many as half of those positions are still on the books. The continued slump in the us bond market has made selling the us side of the trade a much less profitable position. And that’s because without the mutual funds in the game, there still aren’t any buyers. “What we need is to see replacement buyers for us bonds,” says Goldman’s O’Neill. But who will they be? “The us bond market has big-time trouble,” warns Bianco. Even though 1995 was one of the best years ever in the bond market, us stocks still performed two-and-a-half times better, which is why Bianco thinks private domestic investors dumped bonds. “Even the government doesn’t want to buy bonds, and pension funds are increasing their investment in equities.” Last year, foreigners bought $167 billion in treasuries, whereas the treasury issued only $140 billion. More than half the buying was done by two groups: central banks or tax haven countries. The third-biggest buyer was the trading floors of investment banks, who purchased $58 billion. “It was all political and speculative money that bought it last year, and bought it in records,” Bianco says. “The problem is that it’s very fleet-footed and strong-handed. It can be very fickle.” That’s why such widely-varying employment numbers can cause similar effects. “When there’s so much speculative money, if I’m a trader, it doesn’t matter if the number is one job or 100 above consensus, I sell and go short.” Because of its repo volume, the us treasury market is probably the most highly-leveraged securities market in the world. The Fed knows how sensitive it is, and that’s why it has begun to warn the market what action it plans. With both the Fed and the boj seeking to calm the markets with recent pronouncements that rate hikes are not in the immediate offing, the concern seems obvious: investors fear that a Japanese rate hike would be the signal that the global economy is reflating and a us rate hike would follow. But would such actions finally quash the us stock market ebullience and send mutual fund investors back to bonds? Gearing for a fall By any yardstick, such as corporate earnings or short-selling ratios, the us stock market is seriously overvalued, which makes the prognosticators anxious. The initial public offering boom, where companies without any earnings at all trade at incalculable price/earnings ratios, adds to the unease. “The further it goes, the more brutal it will be,” says Bianco. “It will be a killer on the other side.” The viciousness of any downturn usually depends on the amount of leverage being employed. Professionals say leverage has begun to return to the global markets, but because there are no precise data on the debt that is financing mutual fund investments, no- one knows how far leverage exists in the us stock market. The outlook isn’t too promising. “In the aggregate there is probably more leverage in the system than in 1994 [the last time markets collapsed because of a rate hike],” says Henry Kaufman, the former Salomon Brothers economist turned money manager. He points to two indicators – a higher volume of outstanding interest rate swaps and higher corporate borrowing over the past two years. According to statistics from the Fed, net liabilities of non-financial us corporations increased by $735 billion between 1994 and 1995, compared with a total increase of just $133 billion in equity. Investment banks have also been gearing up. Net borrowings against us treasuries by us primary dealers are also at a record high: more than $250 billion, compared to just under $200 billion at the end of 1993. As for mutual funds, Kaufman has long warned of the dangers they represent to the financial system. “The only thing you know is that households have become greater financial risk-takers and that household debt has increased, and that this is the group that invests in mutual funds,” he says. Between 1991 and 1995, such “household” debt (including mortgages) increased by $1.2 trillion, while this group’s investments in mutual funds increased by $656.5 billion. What’s significant is that the debt ballooned during a period of low interest rates, while much of the mutual fund increase is driven by the rising value of equities they already own. It doesn’t take a rocket scientist to see that higher interest rates could easily jack up the debt and deflate the mutual fund numbers. Until now, mutual fund investors’ perseverence has kept volatility in the stock market to a mininum. But Kaufman argues it won’t go on for ever. Structurally, mutual funds consist of short-term liquid assets. “When investors want their money, fund managers must sell some portion of their portfolios.” Unlike traditional financial institutions, he notes, they have neither long-dated financial obligations nor are they able to borrow from the central bank in a crisis. And even though the mutual fund investors are viewed as long-term players, Kaufman says that doesn’t mean their holdings will always be stable. Since most mutual fund investors are middle-aged or older, Kaufman says they are unlikely to resist selling “if their financial nest egg is being threatened by a potential market slide”. Then there are those newcomers to mutual fund investing, who bought into the stock market at high levels. “They are often people who have a relatively high level of debt and therefore modest financial net worth,” Kaufman says. Traditional margin loans on stock purchases have minimal leverage, of two to one. But there are other ways to leverage the market. The extent to which mutual fund investors are financing their purchases with tax-deductible home equity loans, which have been under 8% over the last year, or even through the 5.9% credit card rates being offered, is unknown. But few will deny such financing exists. “In terms of leveraging for investment, when interest rates are at an all-time low, well, if I can borrow at 6% or 7%, and invest and hope to make 10%, I’m still making a spread. I’m sure people are employing that strategy,” says Win Paul, a spokesman at Invesco, a us mutual fund company that manages $14 billion in assets. At the same time, Paul says, “this whole consumer debt picture is blown out of proportion”. It’s just such a sanguine attitude that could be the market’s undoing. Kaufman argues that nightmare of a global market collapse could even occur in an environment not unlike that beginning to be experienced today: moderate global economic growth and steady, or even slowly receding, rates of inflation. Such a benign atmosphere will lull more investors into ever more speculation. “But at some point households will begin to over-extend themselves. Debt to income ratios will reach unsustainable levels, and liquidity will begin to dry up,” Kaufman told a group of European investment managers and corporate finance executives in Milan earlier this year. “When prices do begin to slip from heady levels, the adverse effect on confidence will be sudden and powerful.” Since 1994 there has been much talk of correlation of markets globally. The mutual fund-led us stock market is the only one that has kept its independence, hurtling to new high after high. Mutual funds’ absence from the bond market is already adding to the damage there. But what can happen when those investors lead the next global stock market move is anyone’s guess. “It will be the market equivalent of Britain’s mad cow disease,” quips Bianco. “One day everyone is eating beef, and the next day they want to shoot all the cows.” |
