Once upon a time, credit and economic fundamentals drove returns, investors preached the virtues of asset diversification, and market volatility spiked when macro risk rose.
Then central banks turned up.
Their post-crisis stimulus polices and verbal interventions have conspired to upend the normal functioning of credit markets. Market prices are increasingly driven by cheap liquidity, the Federal Reserve's near-term policy stance, and domestic real rates, rather than market and macro fundamentals, analysts contend.
In a research report last week, Citigroup Inc. credit analysts lamented this brave new world of "deeply dysfunctional" fixed-income and equity markets, citing, among other factors, the broken relationships between corporate profits and credit spreads, and the structural reduction of volatility despite a slew of macro headwinds.
Here are six ways central banks have bred market dysfunction, according to the Citigroup analysts led by Matt King.
1. Macro factors rather than fundamentals are increasingly important in driving returns in developed-world equity markets, a development the analysts say is leading to herding behavior among U.S. mutual funds.
2. With year-to-date defaults now equaling 2015's full-year total, according to S&P Global Inc., high-yield credit spreads in Europe and the U.S. haven't materially adjusted. "With macro this dominant, credit no longer seems bothered by defaults," Citigroup says.
3. The correlation between U.S. corporate spreads and corporate leverage has broken down since 2011, while equity markets echo the fixed-income market's relative nonchalance with respect to bad corporate news. Since 2012, for example, downward revisions to consensus earnings expectations in developed markets haven't been accompanied by equity market sell-offs.
4. In Europe, an uptick in bad news in recent years, as tracked by the Baker, Bloom & Davis economic policy uncertainty indexes, has had little discernible correlation with credit spreads.
5. Long-held relationships between rate and credit markets have broken down. Typically, when the economy is buoyant, government bonds sell-off and corporate spreads tighten as investors reckon good growth prospects justify risk-taking — and vice versa. However, this negative correlation has broken down in recent years, Citigroup notes, citing the relationship between Bund yields and euro investment-grade spreads, as well as U.S. Treasury yields and U.S. corporate spreads. "While it’s never completely clear-cut, these days what’s good for rates is good for credit (and equities) too. Either it all rallies, in a gigantic reach for yield – or it all sells off. The benefits of diversification just went completely out of the window."
6. Volatility is low, despite a rise in cross-asset correlations, and the upcoming U.S. elections, negative news in Japan and political risks in Europe.
As they survey the broken credit-market landscape, the Citigroup analysts seek to explain how central banks have numbed investor allocation strategies based on fundamentals. "Portfolio managers are buying not because their analysts tell them assets are cheap; they’re buying because they have inflows. And when the central bank liquidity taps are turned on, they figure there are still more inflows to come."
They conclude: "And yet the more stretched all these relationships become, and the more extreme the central banks’ policies, the greater is the tail risk."
Still, there are opportunities for credit differentiation in Europe, and strategies to juice returns in a low-rate environment. But as the Bank of England and European Central Bank expand their balance sheets and up their purchases of corporate debt some analysts say yet-more market dysfunction is en route.