Bonds never lie
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Believe whatever you want about equities, but in bonds there is truth.
If you are looking for clarity in the markets, look no further than fixed income.
When the fixed income market is working efficiently - bond prices tell us important things about the economy.
There are plenty of signals this week that vividly reveal what the market assumes.
Right now, the bond market is telling us that the next major debt default will be sovereign, not corporate.
This is positive for US investors and negative for foreign investors.
Before I go into detail, I should note that this week there were no portfolio updates.
Paying subscribers can view last week’s update here.
Brief Newsletter rundown:
Not active but still relevant
The next major default will be Sovereign not Corporate
Deteriorating credit quality
Political Posturing
Elevated Geopolitical risks
Final Word
Not active but still relevant
When we wrote, Bond math doesn't look good back in January 2022, we viewed the debt markets at face value, assumed they were priced to perfection, and worked backward to create scenarios that fit the storyline.
We estimated the probabilities of likely scenarios and compared those scenarios against our internally created base case probabilities.
For scenarios which we saw as highly improbable- we allocated capital aligned with our unique view.
This is why we have not purchased a fixed income security in over 3 years for our clients.
Although we have not actively participated in the fixed income market- we are happy to gain actionable market insights for our investors.
The next major default will be Sovereign not Corporate
We believe the next major default will be sovereign not corporate based on: deteriorating credit quality of countries holding foreign debt, political posturing, and elevated geopolitical risks.
We view this as positive for US investors and negative for foreign investors.
Deteriorating credit quality
Sovereign defaults occur alongside recessions, banking crises, currency crises and other severe shocks.
Moody’s analytics report this week shows the median CDS spread for sovereign debt at junk levels is now over 1,000 bps!
Highlighted below in green.
Remember a wider CDS spread means default insurance is more expensive.
Look at the big difference between corporates and sovereigns.
We view the wide spread at the sovereign level as a clear warning signal.
A recent report by Marc Jones at Reuters titled “The big default? The dozen countries in the danger zone” attempts to identify the dozen or so countries that could be in bigger trouble than the US.
Currently there are 16 countries with 1,000 bps bonds spreads- which is at an all-time high.
While investors have enjoyed low real interest rates for a decade, the push into riskier assets for yield creates outsized risks.
We do not think now is the time to load up on emerging market debt.
While it may be impossible to time the market- estimating sovereign defaults tends to follow a cyclical pattern.
The average debt-to-GDP ratio for sovereign defaulters is 98% since 2010, compared with 71% in the 1997-2010 period.
Consistent with this, sovereign credit ratings respond to macroeconomic factors, such as the GDP growth rate.
The 62% of all defaults began in "bad times," with the output-level being on average 1.6% below trend (Tomz & Wright, 2007).
Bottom line: Markets expect more defaults when economic conditions are worse.
Political Posturing
Sovereign defaults bring out political brinkmanship in all it’s glory.
2020 put the doom and gloom political tactic on full display.
There were six defaults in 2020, including Argentina’s (February 2020), Lebanon (March 2020), Ecuador (April 2020), Suriname (July 2020), Belize (August 2020) and Zambia (November 2020).
It did not matter who was in office.
Aware of their own political career risk, world leaders are in full blown CYA “Cover Your Ass” mode in 2022.
Let me explain:
Did you have to pay your bills in 2020? You might be surprised to learn that most countries did not.
This was due to G20 Debt Service Suspension Initiative:
From May 2020 to December 2021, the initiative suspended $12B in debt-service payments owed by participating countries to their creditors, according to the latest estimates.
In 2022, the training wheels are off.
World leaders are well aware.
You might also be surprised to learn that a “Fed Put” is already codified over in Europe?
This is known as the TPI also known as the transmission protection instrument which was passed earlier this year.
The TPI will be an addition to our toolkit and can be activated to counter unwarranted, disorderly market dynamics that pose a serious threat to the transmission of monetary policy across the euro area.
If required, the TPI will make rich countries like Germany pay for the terrible financial situation in Italy. The ECB plans to do this through unlimited sovereign bond purchases to minimize spreads between eurozone government bond yields.
Bottom Line: Politicians are buying umbrellas for the rainy day.
Elevated Geopolitical risks
Sovereign debt is different because of its ability to post “collateral” in the form of future taxes.
Even with this incredible power- every country is constrained in its ability to raise taxes during periods of heighted geopolitical risks.
The Russian war with Ukraine is a stark example.
The International Monetary Fund (IMF) came out with an interesting working paper in June 2022, addressing sovereign debt and potential policies to mitigate global financial impacts.
The crisis is adding to spending needs as countries seek to mitigate the health and economic effects of the pandemic, while fiscal revenues are falling due to lower economic activity. This has pushed debt levels to new heights close to 100 percent of GDP globally. The ability to carry debt varies widely among countries. Debt vulnerabilities have increased especially in low-income countries and some emerging market economies.
The IMF report then goes through addressing potential prescriptive policies.
In the last 20 years or so, exclusion from international capital markets has become more effective as a channel of legal enforcement of sovereign debt contracts issued under foreign law.
The IMF is not dealing in reality.
Cutting off a country from international capital markets further deepens the problem because a country is no longer able to build itself out of the hole it created.
The war in Russia is a perfect example of how ineffective this type of policy actually is.
Bottom Line: We may not have to wait much longer to see how sovereign default theories play out in real time.
Final Word
Thank you for reading and I am grateful and humbled to be able to learn, grow and invest alongside you at Tuttle Ventures.
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Check out the website or some other work here.
Best,
Darin Tuttle, CFA
NOTE - This is not investment advice. Do your own due diligence. I make no representation, warranty or undertaking, express or implied, as to the accuracy, reliability, completeness, or reasonableness of the information contained in this report. Any assumptions, opinions and estimates expressed in this report constitute my judgment as of the date thereof and is subject to change without notice. Any projections contained in the report are based on a number of assumptions as to market conditions. There is no guarantee that projected outcomes will be achieved. Unless there is a signed Investment Management or Financial Planning Agreement by both parties, Tuttle Ventures is not acting as your financial advisor or in any fiduciary capacity.