The Weekly Update

With just days before the US Presidential Elections, the FOMC held off raising rates last week, at least until the next meeting on December 13-14. This now means that it will have been a whole year since the last Fed rate hike last December back when markets were pricing in 4 rate rises in 2016.

The most notable change in the statement’s language was the addition of the word ‘some’ to the ‘further evidence’ required before a data dependent hike would be warranted. We expect that a not too turbulent Clinton win and payroll data that are in line with expectations could be enough to warrant this ‘some further evidence’.

Friday’s October non-farm payroll release showed 161,000 jobs added which was below expectations of 175,000 although the unemployment rate edged lower to 4.9% from September’s reading of 5%. This follows the US Q3 GDP release which looked strong at the headline number of 2.9% but the underlying data painted a weaker picture. Inventory build was a major contributor increasing from -1.2 percent in the prior quarter to 0.6 percent in Q3. Net exports were also strong contributors giving a 0.8 percent contribution reflecting a surge in soybean exports on the back of a disappointing harvest in Argentina. Final domestic demand was subdued at 1.4 percent quarterly annualised. Business investment remained weak and below expectations growing at 1.2 percent.

We would also note that the September durable goods orders do not bode for a particularly strong Q4 either. More anecdotally, Doug Oberhelman, the Chairman and Chief Executive of the global economic bellwether Caterpillar noted ‘Economic weakness throughout much of the world persists and, as a result, most of our end markets remain challenged.’ More specifically the company noted ‘construction activity and construction equipment sales in North America during the second half of 2016 are now expected to be lower than they expected in the previous 2016 outlook’. Caterpillar has cut its 2016 profit estimate for the third time this year and sees little sign of a recovery expecting 2017 revenues to be similar to 2016.

Nevertheless, Friday’s employment data leads us to expect that the Fed will remain ahead of the curve and raise rates in December; the futures market is now implying 76 percent chance of a rate hike in December although that is based on an assumption of a Clinton election victory. But the key point is that any interest rate increases are likely to be extremely gradual; many of the forces that have been driving neutral rates to lower levels will remain entrenched anchoring interest rate expectations at the long-end of the curve where we favour positioning. We expect the yield curve will flatten from here.

High levels of uncertainty in global markets makes high quality bonds from creditors, particularly those offering positive yields, one of the most attractive places to be positioned. A good example of this would be Kuwait. Last week Al-Qabas newspaper reported that Kuwait is looking to abolish public subsidies on, for example, water, electricity and fuel by 2020. It is estimated that these subsidies along with fiscal support account for ~USD3bn, so roughly 5% of forecasted spending in the current fiscal budget. In September the government partially lifted subsidies, with some fuel prices pushed up by as much as 83%; regular gas is still at a lowly USD 0.28 per litre!

With one of the lowest fiscal and external breakeven oil prices, the Gulf State has been able to weather lower oil prices to a greater extent than some of its regional peers, like Oman and Bahrain for example. However, Kuwait has also been a lot slower at diversifying its economy away from hydrocarbons, compared with its GCC counterparts like Qatar, and thus remains one of the most oil dependant economies in the region in terms of government revenues and exports. 7 star rated Kuwait is the highest ranked country in our Net Foreign Asset (NFA) universe, ahead of Hong Kong and Qatar.

We have in the past held debt issued by the country’s quasi-sovereign issuers, however we cannot find attractive enough value currently. Last week we saw a new deal from Equate Petroleum, a petrochemical producer based in Kuwait. The company issued two tranches in a USD1.25bn deal; the 5-year tranche was issued at +195bps over Mid-swaps while the 10-year launched at MS+270bps or ~255bps over Treasuries. The deal was ~2.3x oversubscribed. Rated Baa2 by Moody’s only, we did NOT add this holding to our portfolios despite the quasi-sovereign nature and strategic importance to the Kuwaiti economy as our proprietary RVM calculated that the bond did not offer an attractive risk-adjusted expected return, nor sufficient credit notch cushion versus other regional holdings within our portfolios. Currently the bond offers an expected return of 4.7% and only 1.4 credit notches of support. By comparison, the new Saudi Government 10-year issue, rated A3, on the other hand offers in excess of 7.2% expected return and almost 4 notches of protection.

Our projections for Net Foreign Assets help us identify the countries likely to be upgraded (or downgraded) owing to current account imbalances, and our RVM allows us to recognise exceptional risk-adjusted value and credit notch cushion within our investable universe. As such, on a weighted average basis, our single A rated portfolios have in excess of 3 notches protection and offer over 3.5% in yield terms. That level of protection also affords us with plenty of opportunity for capital gains if the underlying bonds reprice closer to fair value as we would typically expect.