Aside from favouring investment grade bonds from what we at Stratton Street deem ‘Wealthy Nations’ (NFA ranking above 3 stars), one of our most important criteria for inclusion in the investable universe is risk-adjusted relative value. A great example could be a bond issued by Singapore’s holding company, Temasek 5.375% 2039. Using our proprietary Net Foreign Asset Model, we calculate that Singapore is wealthy, with NFA exceeding 200% of GDP, thus achieving the highest, 7 star ranking. State-owned Temasek in-turn is rated AAA by both Moody's and S&P. In terms of risk adjusted relative value, we calculate that the USD bond maturing in 2039 offers an expected return and yield around 9.2%; thus cheap.
By now you’re likely to have already seen the bashing of Britain’s balance sheet by press – citing the latest IMF Fiscal Monitor Paper. Indeed a minus two trillion pound net worth (3tn in assets minus 5tn of liabilities) is a great headline and a terrifying prospect for those likely to bear this future tax burden. It’s also an embarrassment for many governments (including the UK’s) that have weakened their country’s long-term financial health significantly since the Global Financial Crisis: privatising illiquid assets to create the illusion of lowering public debt and assuming corporate liabilities (UK by 189% of GDP from 2007-08).
Earlier this week, Jean-Claude Trichet, the former President of the ECB between 2003 and 2011 and Governor of the Bank of France from 1993 to 2003, made some interesting comments in an interview with AFP. He said "There is now agreement that the excessive debt level in advanced economies was a key factor in the triggering of the global financial crisis in 2007 and 2008," and that "The growth in debt, especially private debt, in advanced countries has slowed, but this slowdown has been offset by an acceleration of emerging country debt." In Trichet’s opinion: "This makes the entire global financial system at least as vulnerable as it was in 2008, if not more so."
Bad things come in threes, so they say, and this week began with expectations of (at least) a third Emerging Market domino: following Turkey’s and Argentina’s continued fall from grace. Right on schedule, South Africa stepped up, entering its first recession in nine years, then the following day bolstering the disappointment with factory output data down the most in over two years. The slowdown in the agricultural sector was a major driver of the economic weakness, but political and policy uncertainty were also major unquantifiable factors.
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.‘
Intervention reverses lira decline for now, but wider market contagion point to likely further deterioration.
In August alone the Turkish lira depreciated from 5 against the dollar to above 7 earlier this week (it’s always exciting when you can talk about European FX moves in integers) but has today retraced somewhat, dipping below 6 momentarily whilst remaining choppy.
Earlier in the week MSCI announced the inclusion of Saudi Arabia in the Emerging Markets Equity Index in June 2019 following a two step inclusion process. This follows an announcement earlier in the year that the FTSE Russell Emerging Market Index would also include Saudi Arabia (in phases) from March 2019. We would expect Saudi Arabia and its issuers to continue to take a more prominent role in global equity and bond indices, particularly if the proposed listing of Saudi Aramco goes ahead. In our opinion, Saudi Arabia is under-represented in indices for an economy with a 2017 GDP of USD684bn.
The past month has shown debtor nations with excessive net foreign liabilities and dependent on external capital are vulnerable to the Fed tightening policy and reining in US dollar liquidity. At this point in the cycle we continue to favour positioning portfolios in creditor nations and countries with net foreign liabilities less than 50% of GDP: IMF research indicates levels above this threshold are associated with increasing risk of external crises.
Greece is creeping back into the news again as slowly as it is creeping AWAY from its necessary financial reforms. Greece’s third bailout program ends this August, and the Eurogroup have demanded a ‘growth strategy’ by April and set 88 legislative tasks for them to complete by the 21st June to qualify for the final round of the €86 billion bailout package. Furthermore Eurozone finance ministers have yet to agree on any sort of medium-term debt relief to help keep Greece ticking over after August – let alone any contentious long-term relief measures. Continued uncertainty over these will make repeating last year’s successful and oversubscribed bond sale increasingly challenging and expensive.
Not that the German economy has fared poorly in the past four months, but the political stalemate that has endured over that period is finally moving forward - with Chancellor Angela Merkel’s conservatives (CDU/CSU) yesterday agreeing terms for a renewed ‘grand coalition’ with Martin Schulz and the SPD. But many on both sides still oppose the pairing which in some ways seems about as unmelodious as the UK’s Clegg-Cameron-Coalition of yesteryear. So in the typical drawn-out fashion a final vote on the deal, by half a million registered SPD members, is still required and expected by the 4th of March.
Any of our regular readers or longstanding investors will be familiar with our keen appreciation of the merits of Net Foreign Asset (NFA) analysis and our investment philosophy which prefers to divide the investable universe into creditors and debtors. The effects of a country’s NFA position on long term currency direction and creditworthiness was a central theme in the thesis of ours over two decades ago. We used it to identify the incoherent pricing of, for example, Greek debt in late 2009 when yields were at all-time lows of 1.34% while net foreign debts had deteriorated to exceed 100% of GDP (though the country was still A1 rated!).
Yesterday the euro rocketed past the 1.200 mark against the dollar; today it failed to maintain its recent momentum sliding back to around 1.195. Still that’s quite some gain year to date from the 1.05 level it begun the year on, and even further from the warnings of parity that were then forecast for 2017. Much of those previous expectations were based on hopes that Trump’s reforms would boost growth in America and at least one more political domino would fall in the Eurozone during the election season. It’s largely due to the failed-realisation of both of these that the dollar has weakened and the euro strengthened.
‘Whatever it takes’ - Three words that may have saved the Eurozone… for at least 5 years.
‘All the leaders of the 27 countries of Europe… said that the only way out of this present crisis is to have more Europe, not less Europe. A Europe that is founded on four building blocks: a fiscal union, a financial union, an economic union and a political union… there is more progress than it has been acknowledged… [people] underestimate the amount of political capital that is being invested in the euro… we think the euro is irreversible… Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.’
Given the recent spat between Qatar and other Gulf states we’ve summarised some of our analysis of recent and ongoing events within a broader economic and geopolitical context. We continue to monitor the developments but signs increasingly point towards constructive dialogue between the states. Also motivations for a peaceful resolution exist on all sides including Western countries with vested energy and military interests in the region. Moreover, it’s important to consider the country’s risks both on a stand-alone basis but also relative to the market’s pricing - where it continues to offer stand-out value. Qatar’s 30-year bonds yield in excess of 4.4% for AA rated credit from what is the wealthiest country in the world; which according to our models are as much as 5 notches cheap.
South Korea has been captained by a conservative president and government for a decade but that looks almost certain to change next week as those on the tip of the Korean Peninsular exercise their suffrage and demonstrate their displeasure with the recent scandals within the ‘Liberty Korea Party’. Even those who have recently lost faith in polls can reasonably expect Moon Jae-in of the ‘Democratic Party of Korea’ as a shoo-in next Tuesday; he now leads in the polls by double digits (44% vs closest rivals Ahn (23%) and Hong (13%)).
Last week the New York Federal Reserve released their quarterly report on US ‘Household Debt and Credit’. US household debt rose to $12.58tn, with increases in credit card, auto, student and housing loans. This represented a 1.8% increase from the previous quarter and after gradually rising over recent years is now back to 2008 levels in absolute terms. In 2016 US households borrowed a further $460bn in aggregate. On its own this figure is hardly a warning signal, especially as household debts as a percentage of GDP remain well below the ~90% levels of 2008.
According to the 2017 World Happiness Report released yesterday Norway raced ahead three places to be declared the world’s happiest nation, while the Central African Republic is apparently the most unhappy: in a measure of 155 countries. One country rapidly becoming increasingly unhappy is Venezuela, jumping from 44th to 82nd in one year, despite President Nicolás Maduro’s creation of the ‘Vice Ministry of Supreme Social Happiness’ back in 2013. In fact, Venezuela has held the top spot on Bloomberg’s world misery index for three years running, and the country has also caught up with North Korea on the 2017 Index of Economic Freedom, taking its place just ahead of the Democratic People's Republic at 179th place.
With a Federal Funds Target Rate hike expected later today, futures markets have already priced in a 25bp rise following recent strong data, hawkish official comments and waning of external risks. Indeed with USD10bn already shorting Blackrock bond ETFs, announcement swings (if any) could go either way. Focus instead will be on the trajectory of future hikes and any words on future balance sheet reductions. Given that 3-4 hikes were expected in 2016 (and considered gradual back then) a rate rise today supports a similar expectation for the Fed for this year. Three rate rises this year still look more likely than four and we expect any balance sheet reductions will come with the next hike; downplaying their significance.
With the first post-Brexit budget to be delivered tomorrow, the Chancellor of the Exchequer, Philip Hammond, clearly has a lot of priorities to juggle as well as numerous unknowns to try and accommodate for. Preparing a ‘war chest’ for Brexit alongside supporting ailing public sectors (like the prisons and NHS which have received lots of negative press recently) will be challenging enough. Achieving this whilst, ‘making steady progress in eliminating the deficit’ will be significantly more challenging. Yet this is what The Chancellor has promised, also warning that ‘there are still some voices calling for massive borrowing to fund huge spending sprees.
We’re only a few days in to 2017 and Brent oil has already touched $58 per barrel, 11 companies have sold a record $20bn of debt since US financial markets reopened for the New Year and the FTSE 100 has steadily climbed over the holiday period to reach a new all-time high, yesterday clocking over 7,200. But in contrast to these zeniths, overall optimism is still far from all-time highs; as it seems markets are trying to capitalise on short term opportunities whist remaining bearish of longer term prospects. For by no means have all of the root problems of the 2008 Global Financial Crisis been put to rest.