Gordon T Long

Gordon T Long

Global Macro Research | Macro-Technical Analysis 

TIPPING POINTS

CREDIT CONTRACTION

 

SOVEREIGN CREDIT SHAKEN FURTHER BY UKRAINE CONFLICT

The issues within both Sovereign and Corporate Credit have been mounting. Ukraine was just another shock to an already increasingly Fragile sector becoming more “Brittle” by the day, versus the “Resiliency” that is required during dangerous periods of Geo-Political tensions.
 
This can be seen across the Financial Conditions Index, Global Sovereign Credit Default Swaps and Corporate Spreads outlined below. All these charts reflect conditions prior to the Economic and Financial Sanctions just introduced against Russia. 
 
Global banks are now bracing for the ripple effects of these harsh new financial and economic sanctions against Russia intended to hobble its economy and restrict its access to foreign capital.
 
Many now fear this could potentially set off unintended consequences in the form of Credit Contagion.
 
FINANCIAL CONDITIONS INDEX HAS TIGHTENED QUICKLY
 
According to Goldman Sachs the Ukraine conflict has rapidly tightened global (ex-Russia) FCI by 25bps and the global FCI by 50bps, with a much larger effect in Russia itself (800bps). If sustained, such a 25bp FCI move is estimated that it may subtract around ¼% from global growth (excluding Russia) through FCI spillovers.
 
The Geo-Political uncertainty appears to have further lowered the odds of a 50bp Fed hike in March and will likely lead policymakers to stress data dependence even further.
 
ALARMING RISE IN SOVEREIGN CREDIT
 
Already elevated prior to Russia’s invasion of Ukraine, the problem has suddenly become much worse!
 
SURGING RISE IN CREDIT DEFAULT SWAPS PRIOR TO UKRAINE INVASION AND RUSSIAN SANCTIONS
 
    • Russia up nearly70% in latest report ending with a default probability of 5.73% as of 02-25-22. On 02-26-22 Russia’s credit rating was cut to junk by S&P Global Ratings, part of a wide review by all major rating agencies to grade the soundness of the gas-exporting giant’s financial health after the country’s invasion of Ukraine.

Bordering NATO neighbor:

    • Poland + 64.2%

Baltic & Scandinavia States

    • Finland +34.06%
    • Sweden +31.4%

EU members expected to Shoulder Financial Support:

    • France +17.71,
    • Germany +15.38%
    • Belgium +18.35%
    • Denmark +15.19%
    • Austria +11.66%

EU Members that may be choked by reduced liquidity and tighter lending:

    • Portugal +39.68&
    • Spain +35.28%
    • Italy +7.73%
 
PROBLEMS IN EMERGING MARKETS
 
Bloomberg is out with a recent report on “How to Prevent the Coming Sovereign Debt Crisis“. The central issue is that sovereign borrowers, especially in Emerging Markets, need to immediately achieve greater transparency on the size, terms and conditions of obligations it is incurring. It is typical and to be expected that when financial conditions get tough and borrowers desperate, they get creative in hiding material information from lenders.
 
CORPORATE BONDS
 
We have updated the Corporate Bond Outflows chart (to the right) since the last newsletter (LINK). The situation worsens weekly!
 
Clearly as the chart below illustrates, there are presently serious problems in High Yield (HY) and Emerging Market Bonds (EMB).
 
Investors can’t Hedge fast enough. U.S. corporate bond spreads had already been widening as investors “de-risked” on a hawkish Fed. Investors again sold U.S. corporate high-yield and investment-grade bonds on Friday, moving in step with recent weakness in equity markets, and in a sign of risk aversion amid worries about a series of Fed interest rate hikes.
 
EMERGING MARKET BONDS (EMB)
 
According to S&P’s latest Global Ratings Report, recovery is lagging in several emerging markets in Latin America and Africa. For sovereign ratings–which stabilized last year, albeit in many cases at lower levels, after the deterioration in 2020–the evolution of the pandemic continues to be the main risk.
 
  • A more fragile social context and political polarization will limit governments’ capacity to implement revenue and spending rebalancing measures.
  • This year is likely to be one of transition in terms of fiscal consolidation, which, if further delayed, could become a drag on ratings.
  • Rising global interest rates will pose an additional challenge for emerging markets, more so for those heavily reliant on external funding.
 
 
Put open interest for both the largest High Yield Corporate Bond ETF (HYG) and its Investment Grade peer (LQD) has surged to near records. “
 
“HYG and LQD have been a clear focus with more consistent hedging in those products than we have ever seen,” said Chris Murphy, co-head of derivatives strategy at Susquehanna.
 
iShares iBoxx $ Inv Grade Corporate Bond ETF (Top Right)
 
Shorts on credit ETFs have increased by 29% this year, outpacing the overall short-book for U.S. exchange-traded funds, which has risen by 5% in the same stretch. Overall, hedge funds tracked by the bank had at the start of February boosted short positions in every week but one since early November. Even before the Ukraine shock, Investors were already hedging because of the Fed’s hawkish tilt.
 
CONSUMER CREDIT & SAVINGS RATE
 
A prolonged conflict in the Ukraine will deliver a major blow to global markets and slow the normalization of central bank policy that is expected this year. Of course, that slowdown was bound to happen anyway in light of the woeful state of the US consumer, as confirmed by the recent Rent-A-Center earnings and collapse in the personal savings rate (right).
 
A full-blown military conflict, which until recently seemed impossible, is what JPMorgan recently modeled when it predicted an oil price “shock”. This has sent crude as high as $150/barrel in such a scenario. JP Morgan also noted that “this shock would damp annualized growth to 0.9%, assuming the adjustment takes place over two quarters. Inflation would also spike to 7.2%ar, an upward revision of 4%-pts annualized.”
 
In short: the world is now on the verge of a contraction.
 
AN ECONOMIC CONTRACTION WOULD BE A BODY BLOW TO GLOBAL CREDIT OR WORSE!
(see conclusions below on Contagion)
 
 
 
 
BORROWERS v. LENDERS
 
Credit Investors are notoriously more sophisticated readers of the “Tea Leaves” than Equity Market Investors. They don’t invest on “hope and sentiment”. They invest based on fundamentals, valuations and discounted free cash flows!
 
There is nothing harder to find than credit when you need it!
 
CONCLUSION
 
RUSSIAN SANCTIONS MAY BACKFIRE & MATERIALLY IMPACT GLOBAL CREDIT
 
The News York Times is warning that US Sanctions against Russia could have far-reaching and indirect consequences, because Russia is a major exporter of staples like natural gas and wheat. It conducts business with companies and countries around the world. As middlemen, banks typically handle those transactions. Severe economic penalties could disrupt global trade flows if banks are forced to stop processing payments for goods and services going in and out of Russia, according to the Institute of International Finance, a trade association that represents global banks.
 
“The issue here is not just the immediate impact on the financial markets, but the fact that it’s almost impossible in the near term to disentangle Russia from global trade.
There is room for contagion.”
Elina Ribakova, Deputy Chief Economist, Institute of International Finance
 
Sanctions could also spread economic instability worldwide by raising prices for key commodities that Russia produces — including oil, gas, fertilizer and palladium — and spur inflation in countries that import those products, landing a fresh blow just as the world emerges from the pandemic. Russia’s own economy could be relatively protected from the full impact of sanctions. Its external debt and ties to other advanced economies have waned since the 2014 Crimea crisis, insulating its economy from efforts to cut it off from the global financial system, as economists at Capital Economics noted. They predicted that the most likely sanctions measures could shave around 1 percent from Russia’s gross domestic product. The country’s economy has long been dominated by domestic lenders, which only grew in prominence after the 2014 sanctions. European banks, including Raiffeisen Bank and UniCredit Bank, account for most of the 6.3 percent of assets held by foreign lenders in Russia’s banking sector, while U.S. banks hold less than 1 percent, according to the Institute of International Finance.
 
“Russia has a more insulated and isolated economy today than it did a decade ago. This makes it less vulnerable to certain types of sanctions, but its increasing economic isolationism is hurting the country’s growth prospects in the long term.”
Clay Lowery, Executive Vice President, Institute of International Finance
 

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