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'America First' risks making US assets a costly last resort

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America First seems to have become an investment theme by default, as money managers turn to the US in a fraught global environment. The danger is that these flows may be concealing risks in the world's safe haven.

[NEW YORK] America First seems to have become an investment theme by default, as money managers turn to the US in a fraught global environment. The danger is that these flows may be concealing risks in the world's safe haven.

The prospect of the strongest economic expansion since 2005 has helped draw investors to American markets. Geopolitical uncertainty is magnifying the move, despite rising domestic political risks. The per centage of global bond-fund allocations to the US reached 62.6 per cent in August, the highest since 2010, according to the Institute of International Finance. If sustained, this demand could exacerbate distortions: Robust growth and Federal Reserve rate hikes haven't managed to push 10-year Treasury yields above 3 per cent, and credit spreads are near their tightest levels in a decade.

What's more, a vicious cycle may be developing, where US sanctions and tariff threats are driving yet more cash toward American markets. Even with five straight days of losses, the Bloomberg dollar index is still up more than 5 per cent since late March. The strength puts pressure on emerging economies, which have amassed about US$3.7 trillion of dollar-denominated borrowings. One question for investors is whether the US can remain immune to the strains its policies are creating in markets from Turkey to China.

"The dollar debtors out there are all scrambling to find dollars and that contributes to the dollar strength," said Joachim Fels, global economic adviser at Pacific Investment Management Co.

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But Fed rate hikes are gradually removing liquidity, "so the tide is going out and I think that will expose the weaknesses."

The greenback's current bout of weakness also raises the question of how resilient US assets will be in the face of domestic political risks, after President Donald Trump's former lawyer pleaded guilty to federal charges. While the economic backdrop and policies that support further dollar gains remain in place, the resulting uncertainty may give pause to investors seeking refuge in the US.

The tension between global demand for safety and domestic challenges is evident in Treasuries. Buyers are still favoring long-dated debt in the face of record auction sizes as the US seeks to plug an expanding budget deficit. Treasury bulls can cite geopolitical risks to support their case, as well as the threat to US growth from tariffs.

So far, the economy is on solid footing, allowing the Fed to tighten monetary policy, while the Bank of Japan and the European Central Bank continue providing stimulus. Riskier US assets have found support in corporate earnings growth of 25 per cent this reporting period, which has driven the S&P 500 to record highs. In contrast, the MSCI emerging-markets index is down almost 20 per cent from its 2018 peak.

"Things in the US are priced for perfection," said David Kelly, chief global strategist at JPMorgan Asset Management. "There's been a bit of a failure to launch in the rest of the world. We thought that the good momentum last year would be maintained into this year, and that really hasn't been the case for places like EM or Europe or even really Japan."

US credit markets seem particularly impervious to the forces buffeting global markets. But vulnerabilities may be building.

In investment-grade bonds, years of borrowing at cheap rates has fueled debt-driven mergers-and-acquisitions and weakened credit quality. The proportion of bonds in the lowest tier above junk in the Bloomberg Barclays corporate index has jumped to 53 per cent, from 38 per cent in 2007.

The average spread in the corresponding high-yield index is within 30 basis points of the lowest in more than a decade. And as investors have piled into leveraged loans, a record proportion are accepting weaker protections.

American credit markets are too expensive, according to James Athey, senior investment manager at Aberdeen Asset Management, which has shifted much of its US exposure to favour equities over the past year. Still, he finds the US more insulated from geopolitical risks, and better equipped than its peers to fight the next economic downturn.

"When you look further afield, you see other countries which have similar but more acute and more concerning problems," he said.

That said, the support for elevated asset prices may be tested soon. Fels is among analysts expecting US growth to slow in the second half of 2018, and corporate earnings to weaken. The pro-cyclical policy of tax cuts and deregulation may prove to be a sugar high as the expansion enters its 10th year, and the dollar's strength could start to weigh on companies' profits, Mr Fels said.

Investors may not be ignoring these concerns, so much as struggling to measure them, as US policy is in uncharted waters.

"Investors find it very difficult to deal with geopolitical risks in their portfolio construction," Mr Fels said. "It's very different from other risks that investors deal with and are used to: interest-rate risk, credit risk and so on, where we have a lot of instruments to price them."

The flow of cash could reverse if investors start to question whether they're being adequately compensated for US risks.

But so far, they're not balking at the flood of deficit spending and an administration bent on upending longstanding norms. As global financial and geopolitical tensions mount, the money is still following the path of least resistance to its traditional haven.

BLOOMBERG