The Weekly Update

Although last week was volatile, spreads and yields ended the week roughly where they began. The benchmark ten-year US Treasury yield fell to 1.98% by the close on Wednesday but ended the week at 2.05%; one basis point higher over the week. Credit markets saw a similar pattern with US high yield spreads closing at a spread of +818 basis points on Wednesday before rallying to +778 basis points on Friday, one basis point tighter than the previous week.

So where do we go from here? Default risks are clearly rising across a wide range of sub-investment grade issuers from US energy companies on the one hand to oil exporters like Venezuela. However, it would be wrong to assume that the world can simply be divided into oil importers and oil exporters and for investors to steer clear of the latter. Although lower oil prices are in part due to increased supply, they are also a symptom of a lack of global demand. It is the latter which is more important when assessing what happens next. In a deleveraging, low inflation world, it is the debtors that will suffer the most, regardless of whether that country is a net energy importer or exporter. We expect the current deleveraging cycle to lead to further downgrades and in the case of the most indebted nations, eventual default.

The latest country to be downgraded is Poland. Some have described Standard and Poor’s recent move to downgrade Poland’s long-term foreign currency as a ‘shock’ or a ‘surprise’, when the agency cut the rating by 1 notch to BBB+ with a negative outlook (and its local currency rating to A- from A).

We would beg to differ: Poland fails our ‘wealthy nation’ test having a concerning level of net foreign liabilities (“NFL”) to GDP (82.2% in 2012 using Stratton Street’s estimates). We avoid investing in countries with NFL / GDP greater than 50%; IMF research indicates levels above this threshold are associated with increasing risk of external crises. Standard and Poor’s cited the erosion of Poland “institutional checks and balances” following the 2015 election and that they “no longer expect Poland’s fiscal metrics will improve as previously forecast” as reasons for the downgrade. They “anticipate a very gradual reduction of Poland's external debt because the current account deficit will be funded largely through non-debt inflows. …Nevertheless, with net external liabilities at 125% of CARs [current account receipts] in 2015, a prolonged deterioration of external sentiment or increased volatility on global financial markets could weaken Poland's ability to finance its net external liabilities. Our base case is that gross external financing needs will remain fairly constant at approximately 86% of CARs and usable reserves until 2018.”

Using our NFA analysis we made a list of 11 countries to avoid investing in 2009 which were vulnerable due to their NFA positions: Estonia, Hungary, Latvia, Bulgaria, Portugal, Greece, Lithuania, Poland, Romania, Australia and Spain. Subsequently, only 3 of these countries (Australia, Estonia and Romania) have avoided downgrades from Standard and Poor’s or Moody’s on their foreign long term debt.

Indebted nations are under pressure from multiple fronts. Declining growth rates and falling inflation both make it more difficult for countries to grow out of their indebtedness. Added to which, declining currencies cause net foreign assets as a % of GDP to rise, increasing the financing cost even if interest rates remain stable. In the current environment, interest rates are far from stable with financing costs rising for most borrowers, particularly the heavily indebted companies and countries. Although the downgrade of Poland was a shock to many, we expect the downgrade of Australia, when it occurs, will be a much bigger shock to the financial markets.