Back in February 2014 we identified a vulnerable subset of countries that fall in the 1 and 2 star Stratton Street ranking categories, and have net foreign liabilities in excess of 50% of GDP which we collectively named as “Paintbrush”. The nations are Poland, Australia, Indonesia, New Zealand, Turkey, Brazil, Romania, Ukraine, South Africa and Hungary.
Our investment approach favours creditor nations and those with net foreign liabilities (NFL) less than 50% of GDP; as IMF research indicates NFL above this threshold are associated with increasing risk of external crises. 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.
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 with the New Zealand Dollar the best of a bad bunch, declining 23.2% and the Turkish Lira down 79.4%.
From a bond perspective, none of these countries’ Government debt is “cheap” according to our Relative Value Matrix (we had to exclude Australia & New Zealand due to no international debt), which in the case of our US Dollar universe, looks at some 10,000 $ denominated bonds and works an average out for a given rating and duration.
So for example, the current “fair value” spread of an A2 rated bond with a 5 year duration is 68 basis points over US Treasuries. When we say that a bond is trading 3 notches cheap (+3), in this example it would be trading as if it were rated Baa2 (i.e. 3 rating notches lower), and have a spread closer to 146 bps. Two notches expensive (-2) would imply an Aa3 rating, with a spread closer to 41 bps.
Back to Paintbrush. The long dated US Dollar-denominated debt of emerging market heavyweights Brazil & Philippines are the most expensive on the list, trading -3.2 and -4.6 credit notches expensively, respectively. In this case, Brazil (rated Ba2) trades as if it was rated Baa3, and Philippines (rated Baa2) trades as if it were rated a very impressive Aa3.
A final sobering thought for you; if for some reason an external shock were to cause the spread on both bonds to return to “fair value”, we calculate the expected return (over 1 year including the bond yield) would be -41.6% and -20.4% respectively. Thankfully, we couldn’t possibly think of any external shock in the wings, so that’s ok, isn’t it. Isn’t it?