Three snapshots for Thursday
Fears that Athens is on the brink of crashing out of the euro zone and igniting a renewed financial crisis have rattled global markets and alarmed world leaders, with Greece set to figure high on the agenda at a G8 summit later this week. This chart shows the impact on assets since the Greek election:
Euro zone banks now account for only 8% of total euro zone market value – they were over over 20% of the market in 2007:
Japan’s economy rebounded in January-March from a lull in the previous quarter, shaking off the pain of a strong yen and Europe’s debt crisis on solid consumer spending and rebuilding from last year’s earthquake.
South African bond rush
It’s been a great year so far for South African bonds. But can it get better?
Ever since Citi announced on April 16 that South African government bonds would join its World Government Bond Index (WGBI), almost 20 billion rand (over $2.5 billion ) in foreign cash has flooded to the local debt markets in Johannesburg, bringing year-to-date inflows to over 37 billion rand. Last year’s total was 48 billion. Michael Grobler, bond analyst at Johannesburg-based brokerage Afrifocus Securities predicts total 2012 inflows at over 60 billion rand, surpassing the previous 56 billion rand record set in 2o1o:
The assumption..is based on the fact that South Africa will have a much larger and diversified investor base following inclusion in the WGBI expanding beyond the EM debt asset class
Currently South African bonds are restricted to emerging local bond indices. The most-widely used, JPMorgan’s GBI-EM, has less than $200 billion benchmarked to it and South Africa’s weighting is 10 percent. But the WGBI is a different matter altogether — around $2 trillion is estimated to track this index which currently includes just 22 countries, only three of them emerging markets. An expected 0.44 percent weighting for South Africa implies inflows of $5-$9 billion, analysts estimate.
Some of that cash has already come. How much more could roll in this year? Optimists point to Mexico – foreign ownership of the local debt market there rose to 31 percent from 24 percent over 2010, the year the country joined the WGBI, with $11 billion flowing in. But the picture in South Africa is in fact not that rosy. Inflows will undoubtedly pick up, benefiting both bonds and the rand but many reckon positioning in South African bonds is already pretty crowded – about a third of the market is in foreign hands already, analysts at Morgan Stanley reckon. Worse, the country faces a possible credit ratings downgrade this year (all three rating agencies have cut its ratings outlook to negative in recent months).
Kieran Curtis, a fund manager at Aviva Investors upped his holdings of South African local bonds after the WGBI news but is reluctant to go overweight, betting the market will benefit less than Mexico did two years ago. He cites two reasons — first South Africa’s budget deficit has been creeping higher and it follows that debt issuance will too. Second, the external backdrop is less supportive today than two years ago when the Fed was in full money-printing mode:
I wouldnt say I detect a very strong commitment in South Africa to restoring the budget to balance and those debt numbers can rise quickly when you have a 5-6 percent deficit. Also Mexico’s inclusion came at a time when U.S. Treasury yields were falling fairly quickly but now, with Treasury yields rising we may not get the same support for South Africa.
Trading the new normal in India
After a ghastly 2011, Indian stock markets have’t done too badly this year despite the almost constant stream of bad news from India. They are up 12 percent, slightly outperforming other emerging markets, thanks to fairly cheap valuations (by India’s normally expensive standards) and hopes the central bank might cut rates. But foreign inflows, running at $3 billion a month in the first quarter, have tapered off and the underlying mood is pessimistic. Above all, the worry is how much will India’s once turbo-charged economy slow? With the government seemingly in policy stupor, growth is likely to fall under 7 percent this year. News today added to the gloom — exports fell in March for the first time since the 2009 global crisis.
So how are fund managers to play India now? According to David Cornell, who runs an India portfolio at specialist investor Ocean Dial, they must simply get used to the “new normal” — subpar growth and high cost of capital. In this shift, Cornell points out, return on assets in India has fallen from a peak of almost 14 percent in 2007 to less than 10 percent now. While that is still higher than the broader emerging asset class, the advantage has dwindled to less than 1 percent as companies suffer from margin compression and falling turnover. Check out these two graphs from Ocean Dial:
Cornell is playing the new normal by focusing on three sectors — consumer goods, banks and pharmaceuticals. These companies, he says, have pricing power and structural barriers to entry (banks); provide access to still-buoyant demand for services such as mobile phones (consumer goods) and are well-run and profitable (pharmaceuticals). And the export-oriented pharma sector is also an effective hedge against the weakening rupee.
If cost of capital is high, you want to avoid leverage, you want to be in banks which have pricing power. In pharmaceuticals you have 20 percent earnings growth and transparent accounting. In an uncertain environment these sectors should perform well. (Cornell says)
Emerging bond defaults on the rise, no surprise
As may be expected, the crisis has increased the risk of default by emerging market borrowers. According to estimates by ING Bank’s emerging bond guru David Spegel, the default rate on EM bonds is running at over $6 billion in the first four months of 2012, already surpassing the 2011 total of $4.3 billion. He predicts another $1.3 billion of emerging defaults to come this year.
Spegel expects the default rate for speculative grade emerging corporates to rise to 3.25 percent by September, up from 3 percent at present. That doesn’t look too bad, given defaults ran at 13 percent after the 2008 crisis and hit a record of over 30 percent in the 2001-2003 period. But ING data shows some $120 billion worth of corporate bonds trading at “distressed” or “stressed” levels, i.e. at spreads upwards of 700 basis points. The longer such wide spreads persist, the higher the probability of default. A worst case scenario would see a 12.9 percent default rate by end-2012, Spegel says.
Many companies are having trouble rolling over maturing bonds (selling debt to pay off existing creditors). One reason might be the explosion in bond issuance this year. Data from Bank of America/Merrill Lynch shows bond sales by emerging borrowers, sovereign and corporate, totalled 14 billion in the first three months of the year, a quarter more than the same 2011 period. Clearly everyone is rushing to raise cash before U.S. Treasury yields rise further. (see what we wrote on this a few months ago)
Now look at ING’s figures on syndicated bank lending. Syndicated loans are a key funding source for EM borrowers but they have dropped 51 percent in the first three months of 2012 from the previous quarter to $105 billion. Coinciding with the surge in bond issuance and European banks’ problems, this suggests many former bank borrowers have turned to bond markets intead.
What about potential loan defaults? ING estimates $178 billion in syndicated loan repayments remain for 2012 and it is unclear how much of this will spill into bond market issuance. EM debt demand so far has been buoyant, with EPFR data showing inflows of almost $18 billion year-to-date to EM bond funds. Even lower-rated EM companies and countries have easily raised cash. But Spegel warns:
While the abilityof EM borrowers to find alternative sources of funding is positive, the rotation of borrowing from banks to bonds could potentially have negative implications for bond markets if the improving demand dynamics suddenly change direction in face of increasing supply.
Research Radar: Beyond Hollande and Holland…
Markets have been dominated this week so far by the fallout from Sunday’s French presidential election, where Socialist Francois Hollande now looks set to beat incumbent conservative Nicolas Sarkozy in the May 6 runoff , and the collapse of the ruling Dutch coalition on Monday. Public anxiety about budgetary austerity in Europe was further reinforced by news on Monday of a deepening of the euro zone private sector contraction in April. That said, euro equity, bond and currency prices have stabilised relatively quickly even if implied volatility has increased as investors brace for another month or so of political heat in the single currency bloc. The French runoff is now on the same day as the Greek elections and May 31 sees Ireland going to the polls to vote on the EU’s new fiscal compact. Wall St’s volatility gauge, the ViX, is back up toward 20% — better reflecting longer term averages — and relatively risky assets such as emerging market equities remain on the back foot. The euro political heat and slightly slower Q2 world growth pulse will likely keep markets subdued and jittery until mid year at least. At that point, another cyclical upswing in world manufacturing together with the passing of the EBA’s euro bank recapitalisation deadline as well as the introduction of the new European Stability Mechanism may well encourage investors to return at better levels.
Following are some interesting tips from Tuesday’s bank and investment fund research notes:
- JPM economists reckon finding the reason behind the backup in US weekly initial jobless claims over the past couple of weeks is key to assessing whether a sub-par March payrolls report is repeated in April. It says it’s possible the claims jump move is a seasonal factor as unadjusted claims are closely tracking 2007′s pattern and Easter holidays fell on the same dates in both years. If 2007 was repeated, there would be a sizeable late April drop in claims and JPM looks for some of that on Thursday with a 14,000 forecast drop. (Reuters poll consensus is for a 11,000 drop)
- Following the surprise news last week that dovish Bank of England policy maker Adam Posen is no longer voting for more UK money printing, Barclays FX team said it’s turning more positive on the UK economy and also says sticky inflation may mean the Bank of England’s current monetary stance may be too accommodative. As a result, it lowered its euro/sterling 3-month forecast to 0.79 from 0.84. However, it cautioned about being short euro/sterling until after Wednesday’s Q1 UK GDP report, which it said could come in weaker than expected due to temporary factors. (Reuters poll consensus is for a 0.1% rise Q/Q)
- As everyone watches the FOMC outcome on Wednesday, Bank of New York Mellon‘s Simon Derrick highlights widespread expectations of further Bank of Japan easing and asset purchases on Friday. He reckons the economic arguments for more easing in Japan may be sound but it’s worth considering whether BoJ governor Masaaki Shirakawa may want to start facing down heavy political pressure for endless BoJ easing.
- Rabobank‘s emerging markets team flag their concern about Poland’s zloty, which has been one of the best performing currencies of the year so far. They say the zloty is a high “Eurozone beta” play, seen in the correlation of the eur/pln rate with composite euro periphery sovereign CDS spreads, and as a result will suffer if euro tensions rise further over the next month or two.
Hair of the dog? Citi says more LTROs in store
Just as global markets nurse a hangover from their Q1 binge on cheap ECB lending — a circa 1 trillion euro flood of 1%, 3-year loans to euro zone banks in December and February (anodynely dubbed a Long-Term Refinancing Operation) — there’s every chance they may get, or at least need, a proverbial hair of the dog.
At least that’s what Citi chief economist Willem Buiter and team think despite regular insistence from ECB top brass that the recent two-legged LTRO was likely a one off.
Even though Citi late Wednesday nudged up its world growth forecast for a third month running, in keeping with Tuesday’s IMF’s upgrade , it remains significantly more bearish on headline numbers and sees PPP-weighted global growth this year and next at 3.1% and 3.5% compared with the Fund’s call of 3.5% and 4.1%.
But its euro zone calls are gloomiest of all. First off, it sees two consecutive years of economic contraction of the bloc as a whole — a 1.0% shrinkage this year followed by 0.2% drop in 2013. Against this dire backdrop, it expects Spain to be forced to seek Troika (EU, IMF and ECB) support later this year that will be focussed on recapitalizing and restructuring its ailing banks and it also expects both Portugal and Ireland to need second bailouts from the same source.
And with that sort of pressure from deleveraging, austerity, sovereign debt stress and recession , the ECB will have to bring out yet another punchbowl, it reckons.
We expect that renewed EMU strains will prompt the ECB to launch at least one more multi-year LTRO and continue to pencil in one or two more rate cuts by end-2013.
Yet, just like the euphoric effects of both the binge and “morning after” drink, the problem with LTRO is that it risks causing more problems than it solves by tying the banks of weak peripheral euro states ever closer to their ailing sovereigns.
Three snapshots for Wednesday
Spanish house prices fell 7.2 percent in the first quarter from a year earlier while Spanish banks’ bad loans rose to their highest level since October 1994 (see chart).
The Bank of England is poised to turn off its money-printing press next month. Minutes of the Bank’s April meeting, combined with a stark warning on inflation from deputy governor Paul Tucker on the same day, signalled a sharp change in tone that could bring forward expectations for interest rate rises.
Does the E in PE need a reality check too?
Three snapshots for Friday
JPMorgan profit beats expectations:
In China the annual rate of GDP growth in the first quarter slowed to 8.1 percent from 8.9 percent in the previous three months, the National Bureau of Statistics said on Friday, below the 8.3 percent consensus forecast of economists polled by Reuters.
Italian industrial output was weaker than expected in February, falling 0.7 percent after a revised 2.6 percent fall the month before, data showed on Friday. On a work-day adjusted year-on-year basis, output in February fell 6.8 percent, compared to a revised 4.6 percent decline in January.
All in the price in China?
It’s been a while since Chinese stocks earned investors fat profits. Last year the Shanghai market lost 22 percent and the compounded return on equity investments there since 1993 is minus 3 percent. This year too China has underwhelmed, rising less than 3 percent so far. Broader emerging equities on the other hand have just concluded their best first quarter since 1992, with gains of over 13 percent.
Given all that, bears remain a surprisingly rare breed in China. A Bank of America/Merrill Lynch’s monthly survey found it was fund managers’ biggest emerging markets overweight in March and that has been the case for some months now. Clearly, hope dies last.
Driving many of these allocations is valuation. China’s equity market has always tended to trade at a premium to emerging markets but in recent months it has swung into a discount, trading at 9.2 times forward earnings or 10 percent below broader emerging markets. MSCI’s China index is also trading almost 25 percent below its own long-term average, according to this graphic from my colleague Scott Barber (@scottybarber):
There are reasons for the cheapness of course. The economy is slowing and looks on track for its weakest quarter since 2009. Recent corporate earnings have disappointed and there are worries over local government debt and bad loans at banks. The property sector remains a worry and it is unclear if the PBOC will ease monetary policy. But many reckon the problems are in the price.
JPMorgan Asset Management for instance has changed its historic bias against Chinese stocks in its EM fund. China is now the fund’s biggest overweight, more than 5 percent above the MSCI benchmark. Client portfolio manager Emily Whiting expects the market to rebound strongly once investors start unwinding their doomsday bets:
Historically China has been an underweight for us as we always felt the valuations too rich against the broader emerging markets opportunity set.. Now it is our largest overweight country position, we feel the market has priced in too much bad news and it’s created buying opportunities…. it’s a great environment for stock pickers.
Russia’s new Eurobond: what’s the fair price?
Russia’s upcoming dollar bond, the first in two years, should fly off the shelves. It’s good timing — elections are past, the world economy seems to be recovering and crucially for Russia, oil prices are over $125 a barrel. And the rise in core yields has massively tightened emerging markets’ yield premium to U.S. Treasuries, offering an attractive window to raise cash. Russia’s spread premium over Treasuries hit the narrowest levels in 7 months recently and despite some widening this week it is still some 75 basis points below end-2011 levels.
Initial indications from the ongoing roadshow are for a two-tranche bond with 10- and 20-year maturities, possibly raising a total of $3.5 billion.
But market bullishness notwithstanding, investors say Moscow should resist temptation to price the bond too high, a mistake it made during its last foray into global capital markets in April 2010. Fund managers have unpleasant memories of that deal, recalling that Russia unexpectedly tightened the yield offered by 25-28 bps, making the bond an expensive one for investors who had already placed bids. The bond price fell sharply once trading kicked off and yields across the Russian curve rose around 25-30 basis points. Jeremy Brewin, a fund manager at Aviva said:
Russia has a slightly disappointing reputation.. We all ended up paying a tighter spread than we expected. Everyone is concerned they will get pulled in too tight again.
James Croft, head of emerging debt trading at Mitsubishi-UFJ agrees:
The demand for Russian risk is such that getting this bond away should be no problem. The only impediment that could make the transaction harder is investors’ wariness, based on the negative experience of the last deal back in 2010.
Dear Ms. Rao,
A recent claim successfully put forth by the Russian Government before two French courts (see below) could have drastic financial implications for the Russian State’s budget, stemming from the existence of billions of unpaid russian sovereign debt.
We believe credit rating agencies and emerging debt managers should follow developments in this matter very closely.
The current investment grade ratings enjoyed by the Russian Federation are based on a negligent analysis of inaccurate financial data.
The public accounts of the Russian Federation’s financial position make no mention of (and therefore actively dissimulate) the existence of due debt issued or guaranteed by the Russian State prior to 1917.
It has been put forth to the French Senate (Sénat, Commission des Affaires Etrangères de la Défense et des Forces Armées, rapport no. 150 – 1997 – 1998, projet de loi relatif au règlement définitif des créances réciproques entre la France et la Russie, annexe au procès verbal de la séance du 3 décembre 1997) that the 1997 value of this debt was in excess of 40 billion US$.
If the leading credit rating agencies adjusted the Russian Federation’s public accounts, as they should, to include an additional liability of US$ 40 billion this would no doubt lead to a change in their opinion on that State’s capacity to repay debt, and so to the ratings they issue.
While credit rating agencies and the Russian Federation have both argued wrongly in the past, and still do, that debt issued or guaranteed by the Imperial Russian State is not a full faith and credit obligation of the Russian Federation, they may not be able to do so in the future because recent claims sucessfully put forth recently by the Russian Federation have drastically changed the situation.
By successfully claiming ownership, before two French courts (Tribunal de Grande Instance de Nice in 2009 and Cour d’Appel d’Aix en Provence in 2011), of the Orthodox Cathedral in Nice on the grounds that the building had been paid for out of the Imperial Russian State budget and that the Russian Federation was the successor governement to the Imperial Russian State, the Russian Federation has in fact asked the court to acknowledge what defaulted sovereign bondholders have been saying all along: that the Russian Federation is the successor government to the Imperial Russian State and as such is both entitled to claim its assets and bound to pay off Imperial Russia’s debt.
For more on the matter of negligent sovereign debt rating analysis, please visit our website at:
We thank you for your attention.
The Credit Rating Agency Observatory – CRAO
