In my early days as a fund manager markets were only concerned with one data point; the trade balance. That was a very long time ago, and these days markets focus intently on payrolls and the unemployment rate which on the face of it suggest continuing strength in the US economy. However, it’s worth noting that the US unemployment rate hit a cyclical low of 4.4% in May 2007 and yet the US entered recession in December, just seven months later. That example alone should highlight that payroll watching is not really as insightful as some would have you believe.
What is more useful are signs of financial stress and regular readers will be aware that we have been highlighting the housing market as one of our “Canaries in the Coalmine” although there are currently not that many canaries at present.
A new canary may have appeared today though as Banco Santander chose not to call its CoCo bond. We have a particular dislike for this type of bond (when trading close to par at least) as is provides all of the downside of equities with none of the upside. Whilst many market participants trade these bonds as if they will be redeemed on the call date, that is a very dangerous assumption. The bonds are structured so as to convert to equity if certain triggers are met, and whilst that may help the bank in times of stress, that risk is then passed onto the bondholders. Whilst the coupon is higher than regular bonds, 6.25% is nowhere near enough to compensate you for the risk.
Santander’s explanation was that it has an "obligation to assess the economics and balance the interests of all investors." and whilst it may be an issue specific to Santander alone, it could also be reflecting the fact that the world economy is slowing. We will therefore be keeping a close eye on whether other banks choose to follow suit and if they do we will add another canary to our perch in the Stratton Street coalmine.
We remain at the high end of the investment grade spectrum with an average credit rating of single A, as we strongly believe that high quality bonds, from wealthy nations, are the only things to hold when the longer term growth prospects for the global economy, and the US economy in particular continue to deteriorate.