Premier League stragglers Hull, Crystal Palace, Swansea (twice) and Leicester have all sacked their managers this season. The latter is most remarkable given their outstanding title win last season. Club owners fear the financial consequences of falling out of the lucrative top tier and then struggling to climb back.
This fear isn’t new. Over 90 years ago, Arsenal manager Herbert Chapman argued that the fear of relegation was forcing clubs into making short-sighted, rushed and often regrettable decisions. His solution? To relegate half of the league (Great article from the Guardian).
Leicester’s dramatic swing from relegation fighters in 2015 to title winners in 2016 and back down again today mirrors that of financial risk premium. Two years ago the FTSE breached a record high of 7,000. It then collapsed to 5500 last year and is currently making new highs at just under 7,350. We have seen similar gyrations in other markets such as investment-grade and junk credit speads.
As with Leicester, our analysis suggests the underlying position lies somewhere in between: neither awesome nor atrocious, but instead average. We find economic growth, corporate profitability and monetary policy are key drivers of risk premium. The first two have improved over the past year in line with our previous analysis on the manufacturing inventory cycle and the stabilisation of the oil market.
The latter driver (monetary policy), however, is getting worse. With core inflation and wages looking likely to accelerate in the second half of 2017 as the lagged disinflationary effects of the commodity collapse fade, the Fed wants financial conditions to tighten. This can come via a stronger dollar, higher risk-free rates or an increase in risk premiums.
Financial conditions tightened dramatically after the Fed’s first rate hike in December 2015. This scared policy makers, causing them to intervene to ‘stabilize the cycle’ (the Fed delayed hiking while the ECB and BoJ bought more assets).
By contrast, markets are still rallying after the December 2016 hike, perhaps reflecting optimism about Trump fiscal stimulus and deregulation. If ‘taking away the punch bowl’ doesn’t work, perhaps the Fed might need to ‘punch’ or ‘club’ markets around the head to get them to pay attention. This would signal we’re heading into the late cycle.
Fundamentally, we think the drivers of US credit conditions are currently neutral and should deteriorate slightly as the Fed hikes further. Without fiscal stimulus, this would cause growth to moderate. The aggressive rally in financial markets over the past year has challenged that perception. But like football clubs, market risk premium can yo-yo up and down around its average level. Just as Leicester will probably escape relegation, risk premiums might rise further from today’s low levels.