The Weekly Update

The UK leaving the EU and the current UK political crisis could easily be made into a film, with all the backstabbing and twists and turns arriving almost by the minute! In his first major interview since the Brexit result, the UK Chancellor George Osborne has said he plans to slash corporation tax to below 15% in a bid to encourage companies to continue to invest in the UK. At present, corporation tax in the UK stands at 20%, already one of the lowest of any major global economy; it was due to fall to 17% by 2020. Before the vote Osborne had warned that he would have to raise taxes and slash spending in a bid to balance the books by 2020 if the UK voted to leave the EU, however he has now abandoned that target saying the government had to be "realistic about achieving a surplus by the end of the decade".

However, a word of warning has come from Pascal Lamy, the previous head of the World Trade Organization. Lamy said the announcement on corporation tax was in fact the start of the UK’s Brexit negotiations and that this was the wrong way to go about it. Lamy said "The UK is already activating one of the weapons in this negotiation, which is tax dumping, tax competition. I can understand why he (Osborne) does that, because obviously investors are flowing out from the UK, and he wants to provide them with some sort of premium that would make them think twice before they leave the United Kingdom” adding "And I'm quite convinced that at the end of the day, if you want a proper balanced win-win relationship in the future, starting with tax competition is not the right way psychologically to prepare this negotiation."

Breaking EU rules seems to be in vogue in Europe at the moment with the Italian’s trying to negotiate their way to circumvent the EU’s anti-subsidy rules to allow the government to recapitalise the banks. Italy holds a three star ranking under Stratton Street’s Net Foreign Asset (NFA) scoring system with a score of -32% of GDP, putting it in between the UK and the US, also in the three star bucket. The government however is highly indebted with around EUR 2.2tn of debt, about 133% of Italy’s annual economic output.

Italy is rated BBB on average by the three major agencies. According to our Euro Relative Value Model (RVM) “fair value” indicator, the 3-year benchmark should trade around 147bps over Bunds, not at 64bps where they are currently trading, which equates to an actual yield of just negative 3bps per annum. A similar picture is seen at the 5-year maturity where “fair value” is around 175bps over the German Bund curve, but they trade at just +90bps and again at a meagre yield of just 0.3% per annum.

Elsewhere, the National Bank of Abu Dhabi (NBAD) and First Gulf Bank (FGB) are going to merge with a combined balance sheet of around USD 175bn and a combined market value of USD 29.1bn as at June 30th, making this new institution larger than Standard Chartered, Royal Bank of Scotland and Credit Agricole.

Abu Dhabi comes within our NFA system under the UAE and as such is a seven star country with an NFA score of +248% of GDP, but Abu Dhabi does have its own independent rating of AA from all three major agencies.

Currently NBAD has a three year USD bond in issuance, the 3% of 2019, which trades at a yield of 2% which is UST +130bps. “Fair value” according to the RVM is just 56bps for this AA- rated issue and so four credit notches cheap. FGB also has a three year bond, the 3.25% of January 2019 which yields 1.92% or UST +130bps about 2 credit notches cheap against “Fair value" with a spread of 101bps.

Broadly, the message here is Italian government bonds really do not offer anything at all for investors and Italian banks are to be avoided even at their lowly current pricing.

Finally to the much watched employment data from the US. Gone are the days when markets focussed solely on the US trade and current account deficit, which is hardly surprising given that the US has had the largest current account deficit in the world in every year bar one since 1983. Back then the US current account deficit was a modest USD 38.7bn compared to an expected USD 877bn by 2021. Nobody seems to care much these days that US incomes are growing at a rate close to the level of the US current account deficit as a % of GDP. But they should. Measuring incomes without measuring the debt that is accumulated from abroad in order to generate that income is a serious mistake. This point, and the future decline in populations for some of the world’s most indebted nations, underpins the thinking behind the soon-to-be launched Next Generation Global Bond Fund.

Returning to the US data though, June’s non-farm payroll data was much stronger than expectations: 287,000 jobs were added against expectations of +180,000 jobs. The disappointing May figure was revised down to +11,000 jobs from +38,000 jobs and the two monthly revision came in at -6,000. The unemployment rate edged up to 4.9 percent and the participation rate also edged higher to 62.7 percent. The average hourly earnings came in at 2.6 percent yoy, slightly below expectations, and up from 2.5 percent yoy the prior month.

The stronger than expected figure adds some credence to San Francisco Fed President John Williams’ comments earlier this week that the May job weakness was overstated due to the Verizon strike and weather effects: good weather earlier in the year meant more jobs were added earlier in the year which was reflected in the strong February print. Adjusting for these he argued “you basically see a pattern that job growth has continued to be very good, above trend, through the six months of this year.”

Over the past few weeks, the US Treasury yield curve has been flattening; this trend is supported by the negative impact of the Brexit vote on global growth expectations, less confidence in US growth and the Fed’s ability to raise rates, uncertainty driving a ‘flight to safety’ and US dollar strength. Even if US data supports another rate rise we expect the Fed will remain ‘ahead of the curve’ and the yield curve will flatten favouring positioning at the long end on a duration weighted basis.

In a world where close to USD 11.7tn of sovereign yields are trading at negative rates, high quality Eurobonds offering positive yields, particularly from creditor nations, continue to look compelling investments.