From the CEO – April 2018
The flattening of the yield curve in the US, witnessed by a narrowing of the gap between the two- and 10-year Treasury note, was foremost on our minds as PRS/ICRG concluded its forecasts and ratings for the month.
The shape of the curve is important since it is seen as an indicator of expectations of future growth and inflation. And because US bonds are generally seen as ‘safe haven’ investments, the curve has a certain element of caution to it. When the curve flattens and then inverts from its normal slope (viz., rates on the long end of the curve are lower than those on the short end) it is commonly viewed an early-warning sign that a recession is in store.
Indeed, the data shows that, since 1960, the yield curve has inverted nine times with the likelihood of a recession occurring the 12 months following a yield-curve inversion being around 60%.
The flattening curve is expected to continue, especially after a barrage of US economic data released at the end of the month seemed to support the Federal Reserve’s plan to maintain its tightening bias. For example, US GDP rose at an annualized rate of 2.3% in Q1, passing the surveyed estimate of 2%. GDP in Q417 climbed 2.9%. Inflation, for its part, rebounded in the January-March period, with the core personal consumption expenditures index rising at an annualized rate of 2.5% – a stride not seen since 2011.
PRS/ICRG is looking at another two rate hikes this year by the Fed. Looking to 2019, we see three upward adjustments. We’ll articulate more on this in subsequent notes to clients.
The tightening bias of the Fed has also signaled a stronger US dollar against most of the currencies we track – something we began to witness in last month’s data. Indeed, the greenback has risen almost three percent against most of the majors recently and broken through a variety of key momentum measures. For our risk ratings and portfolios, the dollar’s rise against many emerging market currencies is rousing volatility given the large external funding needs for many of these countries. Clients should examine ICRG’s external debt and debt financing tables and accompanying risk scores for further insights.
Speaking of ICRG risk metrics and stock market volatility, a recent study by Professors Suleman and Cermeño found a significant link between the two items. The study (https://lnkd.in/eSf5BTG) measured the connection between country risk (proxied by ICRG’s country composite risk index as well as individual measures of economic, financial and political risk) and volatility of equity market returns.
The data used were monthly data for five major Latin American markets, over the period January 1993 to December 2013, and model stock return volatility as a panel-GARCH process.
Not only did the study find significant and persistent volatility patterns for equity market returns but also high, positive and highly significant cross-correlation among these markets. The study also found strong support for the hypothesis that higher country risk increases stock market volatility.
Given these linkages, what are some of the risks now in emerging markets? A couple are worthy of note. Assuming the yield on the 10-year note reaches 3.5%, longer-dated emerging market bonds would continue to weaken. Also, given the strengthening US dollar, we expect the central banks would begin to raise rates and begin to use their reserves to protect their currencies, something that we’ve noted recently with Argentina and Indonesia. ICRG’s ‘Investment Profile’ risk metrics should therefore be monitored carefully since they provide advance insights into these efforts.
Looking further ahead, the slide in Russia’s currency might be ending for now, as President Trump is seeking a ‘détente’ of sorts, abandoned plans for additional US sanctions on Moscow, and signaled his wish to work more cooperatively with President Putin.
Romania’s leu should also continue to weaken as President Klaus Iohannis has called for the prime minister, Viorica Dancila, to step down from her post saying she is unfit for the position. The move comes after Dancila visited Israel recently without first consulting the president. The prime minister has held the post since January and endorsed a secret deal to move the country’s embassy in Israel to Jerusalem, which overstepped her powers on foreign policy.
Turning to our ratings for the month, we see several risk profiles deteriorating. Poland fell this month as support for the PiS has declined to just under 30% – the lowest in a decade – amidst protests, a controversial abortion bill, and suggestions of improper financial rewards for key politicians, inter alia. Despite this, industrial production continues to hold up rather well and consumer confidence levels remain buoyant for now.
In Portugal, the economy is beginning to slow and pressure is mounting between the Socialist Party minority government and its leftist supporters over changes to the country’s labor laws. Slowing economies in Europe is something we have noted in the past several client letters and we see this as a downside risk/theme for the balance of 2018.
Finally, in India, social turmoil became significant as thousands took to the streets throughout the country to protest continuing sexual assaults of women and girls, sparked by the reprehensible rape and murder of an eight-year old inside a temple in the Jammu area of Indian-administered Kashmir. Watch for more social mobilization as the 2019 elections approach.
On the upside, we see an overall improvement in Sierra Leone as the ruling party candidate was defeated in a run-off vote earlier in the month, handing power to Julius Bio. The generally peaceful transfer of power will have a benign effect on overall political stability, and investors are optimistic as the new administration appears to have economic reform foremost on its forthcoming policy agenda.
Meanwhile, PRS/ICRG is supportive of Egypt’s efforts at improving its investment climate with a new bankruptcy law and some amendments to the capital markets law, providing for greater transparency. According to official figures, foreign direct investment flows rose by 14% during the 2016-17 period – healthy, to be sure, but still below the rate prior to the 2008 world financial crisis and the unrest that began in 2011.
We also remain generally bullish on Saudi Arabia after having visited Riyadh in early April and addressing the Kingdom’s most recent conference on corruption and privatization. The country ranks third in the region (behind Oman and Qatar) in ICRG’s corruption scoring, and investors are awaiting MSCI’s potential classification of the Saudi Stock Exchange (Tadawul) as an emerging market in June. When the upgrade takes effect in May of next year, estimates are that about $14 billion in passive flows that follow the index will be attracted.
ICRG’s April risk ratings were significant in number, as the risk profiles of 55 countries were adjusted, affecting some 75 individual political risk metrics.
Clients and friends should also note that a new book on political risk is slated for a December release. This collection, co-authored by Peter Marber (www.petermarber.com) and Christopher McKee (www.christophermckee.net) will cover topics as diverse as technology and future unknowns, artificial intelligence, new forms of military warfare, foreign direct investment in high-risk environments, as well as concepts and approaches and rating systems. Given its depth and the stature of those writing the various chapters, the book promises to be a landmark contribution to the field.
As is always the case, our data finds its way into some very instructive studies by the IMF. One recent study looked at the relationship between household debt and real GDP growth, using our financial risk metrics as a measure of a country’s ability to ‘pay its way’ by financing its official, commercial and trade debt obligations. (https://lnkd.in/e8sq4Gm)
Another recent piece by the IMF considered whether early warning systems are effective in preventing/mitigating a fiscal crisis. Covering a panel of 119 countries, the study uses a range of ICRG risk metrics to control for government stability, effectiveness, et al., and finds that fiscal adjustment is a good remedy for countries that act proactively, reducing their likelihood of facing fiscal crisis by up to about 60%. (https://lnkd.in/eR7E97k)
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