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Is sovereign risk mispriced in the Eurobond market?

Matein Khalid/Dubai
Filed on June 25, 2017 | Last updated on June 25, 2017 at 06.20 pm
Is sovereign risk mispriced in the Eurobond market?
Janet Yellen was thought to go dovish... but no.

(Reuters)

There is no doubt that mania for yield in low interest rate world has engulfed emerging markets debt

I never thought I would see a sovereign junk (non-investment grade) credit float a $2.75 billion 100-year maturity bond in the international capital market and see it snapped by institutional investors with $9.75 billion in bids in my lifetime. Yet Argentina did just that with its 7.90 per cent yield US dollar bond which I am sure will trade at a premium once it breaks syndicate in the Eurobond new issue market. Argentina's past under its military dictatorships and Peronist kleptocrats is not exactly inspiring: civil war, hyperinflation, multiple sovereign debt defaults, contempt for the rule of law and currency collapses. In 2001, Argentina attained the dubious distinction of becoming history's biggest sovereign defaulter, with $138 billion. Yet 8.25 per cent in US dollars in an ultra-long duration instrument symbolises the new financial/policy regime under President Macri. Is the 100-year issue fairly priced? Yes at a 120 basis spread over the Argie'46 long bond. This deal is the symbol of an emerging debt market U-turn on Latin America's hottest new sovereign credit now that Brazil is mired in another sordid political scandal, Mexico is vulnerable to Trump/oil price crash and Chile is weakened by the end of the copper boom. Argentina's 100 year bond vindicates my faith in the Merval banks in the land of the pampas. Vamos gauchos!

There is no doubt that the mania for yield in the low interest rate world has engulfed emerging markets debt. Russia faces tighter US sanctions, a Urals crude bear market, wide protests in Moscow against President Putin's regime and serous evidence of cyber-espionage conducted by its spies at Lubyanka Central (the seat of the late KGB, now resurrected as the FSB). This did not prevent global investors from bidding $6 billion for 10- and 30-year sovereign Eurobonds priced at a mere 4.25 per cent and 5.25 per cebt yield. I can only quote Lenin's boast when the Bolsheviks won the Russian civil war and launched the New Economic Policy: "We must give the capitalists the rope they need to hang themselves." Like Argentina, Russia has experienced hyperinflation, currency collapse, bank failures and default in my adult life. Amnesia seems mission critical for success in the global bond market in 2017!

It is surreal that the Russian and Argentine new issues hit the financial market after Janet Yellen raised interest rates for the fourth time in a new Federal Reserve monetary tightening cycle and will begin the shrinkage of the US central bank's $4.5 trillion balance sheet. Obviously, the riskiest segment of the Eurobond market does not buy the Fed's hawkish message on growth and inflation. Still, I cannot forget Cicero's comment that "not to know history is to remain forever a child". In June 2013, Ben Bernanke just uttered the word "taper" and precipitated a 100 basis point rise in the ten year US Treasury note yield and a bloodbath in emerging markets debt and equities. Could history repeat itself this autumn? Absolutely, especially if the September FOMC hikes the borrowing rate again for the fifth time in this interest rate cycle.

I had thought Yellen would go dovish at the June FOMC given the weak inflation/growth data as well as the flattening of the two to 10 US Treasury yield curve. Instead, she went hawkish, the reason gold is now $50 below its pre-June FOMC peak at $1244 an ounce. The US Dollar Index has surged from 96 to almost 98. Yet the Federal Reserve's hawkish tilt on inflation and interest rate is being totally ignored by the Eurobond markets as the Russia, Argentina and even Ghana deals suggest. If the Fed's dot plot for 2018 is right, investors will hemorrhage money on the Argentina, Russian and Western African Eurobond news issues. If Yellen is wrong and the US economy moves into recession due to a Fed policy mistake, a spike in emerging market sovereign borrower defaults is inevitable. The darker the berry, the sweeter the juice. The higher the duration, the greater the loss when the music stops - as it always does. The inclusion of Chinese A shares in the MSCI indices is a game-changer in emerging markets equities. This news will unquestionably trigger a bull run in the Shanghai and Shenzhen stock market. Risk is now seriously underpriced in global equities markets. Inflation rates have fallen. US GDP is at a barely 1.5 per cent run rates. US equities are at record highs while the debt market signal recession risk. This reminds me so much about the fateful summer of 2007 when it was party time in the stock market while the credit storm clouds darkened. Value in global markets? The Empire of the Rising Sun!

The writer is a global equities strategist and fund manager. He can be contacted at: mateinkhalid09@gmail.com.


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