The Weekly Update

For some time we have been highlighting that both the US and global economies are much weaker than many people realise. For example, US industrial production is currently in negative territory compared to a year ago. Since 1920 there have been 20 such periods and in 17 of those, the US was ALREADY in recession. We are not yet in a position to forecast a US recession, but the latest jobs data is a cause for concern.

Friday’s non-farm payroll data release for May recorded a gain of just 38k jobs, well below expectations of 160k and compares with a downwardly revised 123k jobs added in April. The two month payroll net revision was -59k  The 3 month average for job creation is now running at only 116k jobs.

Interestingly, the unemployment rate fell to 4.7% in May, from 5%, meaning that 484k people are no longer unemployed compared to last month. Usually, the number of new jobs would have expected to be much larger than 38k as individuals shift from unemployed to being employed. The sharp decline in the unemployment rate whilst jobs gains were weak could be due to a number of factors, the most obvious of which is the fact that the unemployment rate and the payrolls data are based on different surveys. However, the structural decline in the participation rate that we have seen since mid-2000 is entirely consistent with the idea that Americans are choosing not to work as they get older. Ageing populations are a serious problem for many countries, particularly those that are already indebted. Analysis of demographic trends, for which forecasts are very accurate as we know the number of people that were born, 10, 20 and 30 years ago, suggest a further weakening of global growth in the decades to come with inflation at very low, or even negative levels. This conclusion, along with our projections for indebtedness levels (which deteriorate as populations shrink) underpins the strategy behind our forthcoming launch of the Next Generation Global Bond Fund which we hope to launch in early July.

We have long believed that the antiquated terms “developed” and “developing”, which are so often used to distinguish between countries’ wealth and standard of living neither represent a country’s financial risk, nor their economic global impact. We were therefore pleased to hear this week that the World Bank has dropped the “developing country” classification from its World Development Indicators, as the term has become “less relevant”.

The categorisation is based on a country’s Gross National Income (GNI) per capita using the “Atlas conversion factor”, where 2/3rds of the world’s countries were classified as “developing”; having fallen into the “low and middle-income economy” categories. This is not to say that the “developed/developing” classifications have not been useful proxies, however, considered more an art than a science, there is no clear-cut blanket definition, especially if we are looking at investment risk.

At Stratton Street we prefer to use the net foreign asset (NFA) position to analyse a country, and hence investment risk. The NFA uses a country’s current account, which measures the flow of assets for the country as a whole, and so captures the build-up of assets or liabilities not just of the government, but also the debt or asset accumulation of corporates, banks and individuals. Consequently, the concept of NFA measures the aggregate savings or borrowings of the entire country, not just government debt. Our model assigns a 1-7 star rating to a country using its NFA as a percentage of GDP; a 3 star country for example has net foreign LIABILITIES (NFL % of GDP) below 50%, whereas 7 stars are given to a nation with over 100% net foreign ASSETS (NFA % of GDP). Using this method, we can automatically reject a number of countries, i.e. those with high NFL.

If we take the examples of Portugal, Turkey and China, which have GNI per capita (PPP) of $21.3k, $10.8k and $7.4k; Portugal fell under “developed” while the latter were classed as “developing”. We could then look at their respective credit ratings; Ba1, Baa3 and Aa3, just from that the “developing” nations look less-risky, and China has several notches of protection. NB: We have never been holders of debt issued by Turkey or Portugal. Now if we look at our 2016 NFA star ratings, Portugal is 1 star, Turkey only has 2 stars while China has been assigned 5 stars. So to us the World Bank measures, although evolving and helpful in the correct application, do not truly depict the risk one faces if their investment is based on such categorisation;  “developed/developing”,  or “frontier” and “emerging” etc. for that matter.

Hopefully other institutions will move away from these definitions just as they have from describing nations as first, second or third world; categories which primarily describe a country's affiliation with capitalism or communism. Defining China as “developing” is just as unhelpful as thinking of South Korea as Third World, yet many still insist on doing so. Meanwhile we will continue to look for value in our 3-7 star nations and remain cautious of the many overlooked risks in “developed” markets.

Viewing the world in terms of debtors and creditors, rather than emerging or developed has been a theme of ours for many, many years and the Next Generation Global Bond Fund will continue with this approach although we will be adding the flexibility to hold sub-investment grade positions as well. In addition, our analysis of creditors and debtors also leads to some strongly held views on currencies, which the new fund will also be able to exploit. Without giving away too much, we can highlight that the US dollar and Sterling fare relatively badly based on current projections.