The Daily Update - Pricing Developed Country Political Risks - A Tale Of Two Nations

Consider two countries: one with high public debt and Net Foreign Liabilities rated Baa2 versus one without Net Foreign Liabilities rated Ba1. History has shown that high levels of indebtedness greatly increase financial risks to creditors as investor sentiment becomes more volatile and repayment costs balloon.  We believe the risks of this greatly increase when Net Foreign Liabilities exceed 50% of GDP and are typically unsustainable beyond 100% of GDP.  Yet there are numerous examples across the world where countries with high levels of indebtedness are rated higher than net foreign creditors or countries with appropriate and sustainable levels of debt. Why is this?

The obvious answer is that financial metrics are not the only measure of investment risks. Political and institutional strength are also key; both of which for a long time have driven higher credit quality and lower borrowing costs for 'developed economies' in comparison to countries considered 'emerging markets'. But how quickly can such political and institutional structures vary for good or for ill, particularly in developed economies? And when they do waver how quickly can this affect credit quality and market sentiment?

For the last half century the political and institutional strength of most advanced economies has proven relatively stable on the back of broadly comfortable levels of peacetime growth; so much so that it can easily feel like this should always be the case. Up until 2016 that was; right before a Eurozone financial and migration crisis, Brexit and Trump et al. Now it seems such institutional resilience should no longer be considered implicit just because the country had its industrial revolution one or two centuries ago. So what happens now to those heavily indebted nations which previously received favourable borrowing costs but no longer show greater political stability in the face of swarming popular unrest?

In a recent report titled 'A Spotlight On Rising Political Risks' Standard and Poor's hinted at their cautious view of this changing environment stating, 'it may no longer be possible to separate advanced economies from emerging markets by describing their political systems as displaying superior levels of stability, effectiveness, and predictability of policy making and political institutions.' Of course rising political risks are not exclusive to advanced countries in the months ahead but what is different is that markets are less used to factoring in such uncertainty for countries like the U.S., U.K. and France.

The first of the two countries we were considering at the outlook was Italy and the second was Russia. On the same day as the aforementioned report, Moody's changed its outlook on Italy to negative following the rejection of constitutional reform and breakdown of current leadership. Yet remaining 2 ratings notches above Russia does not seem to reflect the real potential of Italy electing a 'Five Star' (in name only) movement to take the helm of a vulnerable economy with little experience, or the likely prolonged political inability to push through the necessary ongoing economic and fiscal reforms. Without these reforms Italy’s net debts could soon reach unsustainable levels.


From a credit investing perspective Russia seems the more attractive investment. Not only does it offer a more attractive yield for 10 year debt in comparison to Italy (4.4% in USD vs 2.3% in EUR for the BTPS) but it has shown recent adaptiveness and ability to the lower oil prices and sanctions. In light of Russia's recent announcement of increasing its FX reserves (see yesterday’s daily) and potential for relaxation of sanctions an upgrade seems forthcoming and with Italy's negative outlook and deteriorating financial and institutional strength a downgrade perhaps seems likely in 2017. So for two countries that could very well have the same rating soon we far prefer the one with a higher yield and greater potential for price performance.

Please read this important information before proceeding. It contains legal and regulatory notices relevant to the information on this site.

This website provides information about Stratton Street Capital LLP ("Stratton Street"). Stratton Street is authorised and regulated by the UK's Financial Conduct Authority. The content of this website has been prepared by Stratton Street from its records and is believed to be accurate but we do not accept any liability or responsibility in respect of the information of any views expressed herein. The information, material and content provided in the pages of this website may be changed at any time by us. Information on this website may be out of date and may not be updated or removed.

The website is provided for the main purpose of providing generic information on Stratton Street and on our investment philosophy for the use of financial professionals in the United Kingdom that qualify as Professional Clients or Eligible Counterparties under the rules of the United Kingdom Financial Conduct Authority (the "FCA"). The information in this website is not intended for the use of and should not be relied on by any person who would qualify as a Retail Client. Products and services referred to on this website are offered only at times when, and in jurisdictions where, they may be lawfully offered. The information on this website is not directed to any person in the United States. The provision of the information on this website does not constitute an offer to purchase securities to any person in the United States (other than a professional fiduciary acting for the account of a non-U.S person) or to any U.S. person as such term is defined under the Securities Act of 1933, as amended.

The website is not intended to offer investors the opportunity to invest in any Alternative Investment Fund ("AIF") product. The AIFs managed by Stratton Street are not being marketed in the European Economic Area ("EEA") and any eligible potential investor from the EEA who wishes to obtain information on the AIFs will only be provided with materials upon receipt by Stratton Street of an appropriate reverse solicitation request in accordance with the requirements of the EU Alternative Investment Fund Managers Directive ("AIFMD") and national law in their home jurisdiction. By proceeding you confirm that you are not accessing this website in the context of a potential investment by an EEA investor in the AIFs managed by Stratton Street and that you have read, understood and agree to these terms.

No information contained in this website should be deemed to constitute the provision of financial, investment or other professional advice in any way. The website should not be relied upon as including sufficient information to support any investment decision. If you are in doubt as to the appropriate course of action we recommend that you consult your own independent financial adviser, stockbroker, solicitor, accountant or other professional adviser. Past performance is not necessarily a guide to the future. The value of investments and the income from them may go down as well as up. An application for any investment or service referred to on this site may only be made on the basis of the offer document, key features, prospectus or other applicable terms relating to the specific investment or service.

Where we provide hypertext links to other locations on the Internet, we do so for information purposes only. We are not responsible for the content of any other websites or pages linked to or linking to this website. We have not verified the content of any such websites. Such websites may contain products and services that are not authorised in your jurisdiction. Following links to any other websites or pages shall be at your own risk and we shall not be responsible or liable for any damages or in other way in connection with linking.

By using this site, you should be aware that we may disclose any information that we hold about you to any regulatory authority to which we are subject, or to any person legally empowered to require such information.

This website uses cookies to improve user experience, by clicking the "I Accept" button below means you consent to the use of cookies on our website.