Earlier this week S&P published a report highlighting the importance of a large stock of liquid government assets in supporting a sovereign rating: ‘when government assets exceed 100% of GDP, the positive effects are visible throughout our analysis, and this is currently the case for only seven sovereigns we rate. Topping that group is Kuwait, followed by Norway and Abu Dhabi.’ The report goes on to note: ‘Our ratings on Kuwait and Abu Dhabi remained stable at 'AA' throughout the recent slump in oil prices, underlining the rating stability provided by having large liquid assets.‘
At Stratton Street we have long been proponents of the importance of net foreign assets (NFA) in screening for countries that we would like exposure to. We favour creditor nations and those with net foreign liabilities (NFL) less than 50% of GDP. IMF research indicates NFL above this threshold are associated with increasing risk of external crises and as we have recently seen a number of debtors’ asset markets have come under pressure as the Fed continues to tighten and rein in US dollar liquidity.
Countries with net foreign assets are less reliant on foreign inflows than those with net foreign liabilities and over the longer term creditors’ currencies tend to appreciate while those of heavy debtors tend to depreciate. Back in February 2014 Stratton Street highlighted a list of vulnerable countries with large net foreign liabilities which we collectively named as ‘PAINTBRUSH’. These countries, in no particular order of level of concern, are Poland, Australia, Indonesia, New Zealand, Turkey, Brazil, Romania, Ukraine, South Africa and Hungary. As a guide, since the end of February 2014 none of these countries’ currencies (spot rate) are showing a positive return against the US dollar: the Turkish lira is the worst performer down 66.1% closely followed by the Ukrainian Hryvnia down 64.8% and the Brazilian real down 43.5%. The Polish Zloty is the best performer down 18.1% (spot basis). In contrast, the currencies of creditor nations such as Singapore, China, Japan and Switzerland have performed better although over this time period the US dollar index (DXY) has appreciated.
To put these moves into some form of perspective, in August 2008 the Global Financial Crisis had only just begun (Lehman’s filed for bankruptcy in September 2008) and between the end of August and the end of the year the Turkish Lira had fallen by 22.9%, the Ukrainian Hryvnia declined by 40.2%, with the Polish Zloty falling by 23.4%. Meanwhile, 10 year Treasuries declined by 160 basis point during that period, ending the year at 2.2%.
Past performance in no guide to the future, but deleveraging phases always follow a predictable pattern with the PAINTBRUSH currencies always declining more than the currencies of creditor nations. Equally, government bonds always rally in a flight to quality move so it seems more than a little surprising that the market is still running record short positions in US Treasuries. We all know about the “pain trade”, the tendency for markets to deliver the maximum amount of pain to the most investors as a popular strategy takes an unexpected twist. Maybe those investors should pay more attention to the PAINTBRUSH currencies, after all the first four letters should serve as a reminder as to what happens when a crowded trade starts to go wrong.