Six big risks facing global markets in 2016
Published 23/11/2015 | 08:27
Investors are facing a growing number of risks as global capital markets enter 2016, with many of the central pillars that have supported a record bull run during the past six years looking decidedly shaky.
Bond market rout
Companies that should never have been able to borrow money have done so in record amounts due to years of near-zero interest rates. However, the era of profligate lending is now coming to a close.
In the US energy sector record low oil prices have placed extreme strain on the finances of shale oil drillers. Chesapeake Energy was one of the largest shale oil drilling companies in the US and the second-biggest issuer of junk bonds in the sector, raising $11bn from investors.
Drilling for shale oil is a loss making enterprise as oil prices have fallen below $40 a barrel. Chesapeake bonds collapsed to 48 cents last week as investor’s face being completely wiped out. The cost of insurance on Chesapeake bonds – or credit default swaps – soared as holders of the bonds desperately try and cover their losses.
Emerging market credit crisis
The shale oil drillers are by no means the only companies in trouble. Many conventional oil production companies from the North Sea to the Gulf of Mexico rely on an assessment of the value of their oil reserves, or reserves based lending, to determine how much they can borrow.
Banks cut back the amount of lending to North Sea oil explorer Ithaca Energy earlier this month as the value of its reserves was downgraded to reflect current prices. This move by the banks marks one of the first times that lending to the sector has been cut. As the access to finance is reduced an increasing number of weaker companies will fail next year.
The energy sector may be in serious trouble, but the problem can still be contained as it only represents about 15pc of the wider junk bond market.
The bigger issue is in emerging market debt. Commodity focused corporates in Brazil, Russia, India and China that have borrowed in US dollars will face ruin next year.
The rising value of the US dollar and collapse of emerging market currencies will make repayments unaffordable for many.
The crisis has already spread from energy to pharmaceuticals. Valeant was one of the largest ever junk issuers when it issued $10bn in bonds to buy Salix in March this year.
The Canadian drug group has seen its shares collapse and bonds fall sharply after a report by shortseller Citron Research, which questioned the aggressive expansion and accuracy of sales numbers through its network of pharmacies. Valeant strongly denies the allegations but the damage has been done.
Stepping back from the specific allegations at Valeant the wider issue here is a company that has been allowed to grow incredibly quickly through acquisitions fuelled by cheap debt. A situation that could only exist with borrowing as cheap as it is.
The collapse of the junk bond market will reach far and wide. In the past, the junk bond market has only really been used by professional investors or those with a higher risk appetite. As interest rates were cut from 2009 onwards retail investors, pension funds and insurance companies alike have all ploughed billions into high-yield bonds.
Dividends under pressure
The rising cost of borrowing will place further pressure on companies that pay big dividends in 2016. Many companies have used cheap borrowing to increase earnings through buying back shares and returning cash to investors through dividends. The rising cost of borrowing will make those strategies more difficult.
The top five companies in the FTSE 100 pay out 35pc of all the dividends to UK investors, and the biggest dividend paying sectors are commodities and banking.
Seven FTSE 100 companies cut their dividends this year Antofagasta, Centrica, Glencore, Morrisons, Standard Chartered and Tesco. As earnings fall and borrowing costs rise then they won’t be the last. The dividend yield is an important factor for supporting the valuation of the stock market and as it comes under threat share prices will come under further pressure in 2016.
The FTSE 100 suffered a 13pc fall in August and is down 3.5pc so far this year, it is still not good value and needs to fall much further before reaching attractive prices.
The FTSE 100 trades on a forward PE ratio of 16 times earnings, a premium to the long run average of 15, and that looks expensive given that earnings will come under pressure next year.
Global capital flows
The global equity market faces a further headache next year as sovereign wealth funds that have pumped money into shares are forced to sell holdings to plug holes in their budgets.
From the mighty Norwegian sovereign wealth fund to Qatar and the oil-rich Kingdom of Saudi Arabia they are all running short of cash with oil at current prices.
That deafening sucking sound is the reversal of a two decade flow of petro dollars into Western capital markets. The selling will accelerate next year placing even greater pressure on equity markets around the world.
The shape and tone for global markets in 2016 will be set within two crucial weeks next month. The first is the Opec meeting which begins on December 4 and the second is the US Federal Reserve meeting which begins on December 17.
If Opec hold oil production steady and US interest rates begin to rise then investors can expect further losses next year. Global markets are ill prepared to reprice risk after years of borrowing with no consequences.