Video didn’t kill the radio star… and neither did supply chains
The current crisis in the UK, caused by the fiscal measures announced by the new government, occupied many investors last week. The Bank of England immediately postponed its quantitative tightening process, while scenario developments and discussions between monetary, fiscal and political authorities punctuated the week.
The first set of questions concerned the UK itself. Doesn't the path chosen by Prime Minister Liz Truss’ government – which didn’t consult the Office for Budget Responsibility as is traditional – risk pushing the country further into difficulty? The answer is yes. The fall in the value of the pound, the explosion of gilts and uncertainty will slow growth even more in the coming quarters.
Besides, is the UK an advanced example of the situation in other countries, most notably Italy? Our answer is no. Italian spreads have only risen by about 10 basis points over the month of September. While the level of Italian debt is worrying and growth potential anemic, the dual shield of the ECB and the European stimulus funds are playing their role as a shock absorber.
Finally, in the current context the risks of financial contagion have been the main concern of investors. It has already contributed to the strengthening of the US dollar at an inopportune moment (see The cycle and the spreads, 27 September ). The volatility shock could lead to liquidations and bankruptcies. A default by a major company, or even a bank, would further accentuate the risks of contagion, even if the BoE is watching very closely.
In any case, three things stood out for our portfolio managers: a review of positions linked to the island’s economy (i.e. not all companies will go bankrupt); the strengthening of currency hedges, and the purchase of short maturity Treasuries, without the dollar risk (see next story).
The July US housing price data were in the spotlight last week. Why? Because they account for over 32% of total inflation and 40% of core inflation.
As the chart above shows, regardless of the many measures used in the US, the year-on-year increase in prices and rents has been decelerating for a few months. But in July, they began to fall in absolute terms month over month by 0.6% according to the Federal Housing Agency index and by 0.4% according to the Case-Shiller index.
The drop in prices, even if it surprised expectations by its magnitude, is not surprising given the decline in activity in the sector, which is in recession, and the rise in mortgage rates, which recently reached 7% for the 30-year. The evolution of real estate loan applications and the US Federal Reserve's monetary policy clearly indicate that the decline is not over.
At this stage, the dynamics of real estate activity and prices should not cause the Fed to change its policy. This is not 2007. On the other hand, it is a strong argument for not accelerating the pace of rate hikes, or even slowing them down. The Reserve Bank of Australia’s decision this morning to hike by “only” 25 bps –against expectations of 50 bps – may signal a deceleration is on course in the “Great Tightening” trend. This is good news for global monetary conditions, the cycle and the spreads.
Last week, emerging market bonds faced outflows of USD 4.2 billion, the largest since March 2020 amid the ongoing global markets pessimism. That’s equivalent to 1.1% of the sector’s assets under management. The outflows were broad based, affecting both local currency (-USD 1.1 billion) and hard-currency bonds (-USD 3.1 billion). The Emerging Markets Bond Index Global Diversified (hard-currency sovereign) fell by 3.1% while the Government Bond Index-Emerging Markets (local currency) fell by 1.6%.
The market reaction could have been worse considering the magnitude of the outflows. High-yield hard-currency issuers were particularly affected (-3.9% compared to -2.4 for investment grade) with spreads widening by 75 bps.
This latest selloff has increased the number of sovereigns with spreads above 1,000 bps from 16 to 19, temporarily reducing their ability to access global capital markets, even though nothing has fundamentally changed for these countries.
The three new additions to this stressed club are Egypt, Kenya and Nigeria. For Egypt, we continue to expect a deal with the International Monetary Fund to come to fruition before year-end, which should catalyze large investments from Gulf countries and cover the country’s external financing needs.
Kenya and Nigeria do not have urgent balance of payment needs and can stay out of the markets for longer. Kenya need not come to the markets until 2024 and Nigeria remains an infrequent issuer with low debt. Thus, we’re not particularly concerned about these countries in the short term.
We use these market swings as opportunities to switch between liquid high-yield and illiquid high-yield issuers. When the market bounces back (like in August and September), we have tended to reduce our relatively liquid high-yield positions, such as Egypt, reducing risk in a contrarian fashion. At the same time, we tend to buy liquid high-yield risk when the market sells off (like now) and reduce our illiquid high-yield issuers positions during the selloff.
This is because illiquid positions are typically stickier and sell off less (i.e. resilient to turmoil) but also rally less. Thus, they tend to be cheap when the market rallies and relatively expensive when the market sells off. This is one of many ways in which our contrarian approach allows us to generate alpha through the cycle.