Last week began with markets digesting further growth downgrades from the OECD alongside a report from the Bank of International Settlements (BIS) warning about the growing risks of high-risk lending and leveraged loans. The week ended (also closing out the third quarter) with escalating US-China trade disputes contrasting news of the new US-Mexico-Canada Agreement, or USMCA, to supersede the eschewed NAFTA. US equities mostly maintained a tight (10 point) range over the week apart from a temporary dip following Thursday’s anticipated quarter-point hike of the Fed Funds Target Rate to 2% (lower bound), whilst US 10-year Treasury yields closed the week where they started at 3.06%.
According to the BIS the total of leveraged loans and high yield bonds outstanding in the US and Europe has doubled to $2.65 trillion since the financial crisis and while high yield accounts for more than half of the amount, leverage loans now account for around 45%. The BIS is concerned regarding the trend to covenant-light lending where investors are waiving protection in the search for higher yields. Moody’s Investor Services in a recent review point out that 80% of newly issued loans are now covenant-light and their index which measures covenant strength is at an all-time high indicating weaker borrower protection. The BIS report suggests that the prospect of ‘fire sales’ by leveraged mutual funds is indeed a real risk should ratings downgrades pick up putting bank balance sheets at risk.
As expected, on Wednesday the FOMC raised the federal funds rate 25 bps to 2.00-2.25%, with the forecasts for the dot medians unchanged at 2.375%, 3.125%, and 3.375% for 2018, 2019, and 2020 respectively and the 2021 median now coming in the same as 2020 at 3.375%. The Fed also revised up from their June forecast of GDP growth for both 2018 and 2019, however generally retained their view that the growth rate will drop back to 2% in 2020 and 1.8% in 2021. In the statement after the announcement, the Fed removed a phrase that noted that policy remains ‘accommodative’, a change that was hinted at strongly in the August minutes. There was no mention of an update to the Fed’s current balance sheet policy.
Elsewhere, European stocks almost managed to remain steady for the week but were upset on Friday after Italy’s coalition government agreed a 2.4% budget deficit goal for 2019: triple what was planned by the previous government. As Pierre Moscovici, the European Economics Commissioner put it ‘We don’t have any interest either that Italy does not respect the rules and does not reduce its debt, which remains explosive’. Alongside this, the European Commission’s Economic Sentiment Indicators highlighted Eurozone business and consumer confidence falling to their lowest levels in over a year.
The week ahead begins with four drawn-out days for Prime Minister Theresa May and the Conservative Party annual conference, where she is expected to attempt healing the growing divisions within her party whilst trying to supress Brexit and leadership contestations. US jobs data hits the wire on Friday as does policy news from the Reserve Bank of India where it is uncertain if the RBI will raise rates following a challenging quarter: with oil topping $80 whilst the rupee, down over 12% year-to-date, continues to make record lows. Lastly over the weekend Brazil will head to the polls for a swathe of simultaneous elections for President, Congress, federal legislative and state legislative and governors.