Why investors in emerging-market bonds are so attuned to political risk

They must divine not only ability to repay, but willingness

PAULO GUEDES might not be your first-choice brother-in-law. He is a close adviser to Jair Bolsonaro, Brazil’s populist president-elect, who is wistful for military rule. But if you invest in emerging-market government bonds, Mr Guedes is the sort of person you might want as economy minister, the post he will take up on January 1st. He was co-founder of BTG Pactual, Brazil’s Goldman Sachs. He has a PhD in economics from the University of Chicago. He favours tax reform and privatisation.

Brazil is not the only focus of attention for such investors. This week Andrés Manuel López Obrador, a left-leaning populist, was sworn in as president of Mexico. He has cancelled a $13bn bond-financed airport that is already one-third-built. In November a committee of South Africa’s parliament resolved that the constitution should permit land reform without compensation. Some have begun to worry about what Narendra Modi might do to secure re-election as India’s prime minister next year.

A host of emerging-market political risks seem suddenly to be salient. These are not amenable to being tallied in a spreadsheet. Nor is the curriculum vitae of the finance minister really much use. For bondholders, the worry is that bad politics will lead ultimately to bad debts. When your upside is capped at getting your money back with interest, you tend to worry more about your downside.

To trade emerging-market bonds you need to know two things, says Jan Dehn, of Ashmore, an investment firm: a country’s ability to pay its debts—and its willingness. A spreadsheet is useful when reckoning ability to pay. The debt-to-GDP ratio is a good shorthand. Emerging markets have a lower ratio (the average is 50%) than rich countries (105%), whose bonds are for the most part considered a safe store of value. There is no magic threshold at which default risk becomes acute. But as a practical matter, investors are less jumpy when the debt ratio is stable or falling.

Whether it rises or falls depends on interest rates, GDP growth and the size of the primary budget balance (ie, before interest payments). The more interest rates exceed GDP growth, the bigger the primary surplus must be to stop the debt ratio rising. In this regard, Mexico and Brazil are a study in contrasts. Mexico’s debt ratio is near the average and stable. Brazil’s, at 84%, is large and rising fast.

When ability to pay is in question, a country’s willingness to pay is critical. A government is forced to choose between its debtors and others with a claim on its money, like civil servants and pensioners. A lot depends on the interests of political players. Take Brazil. Mr Guedes’s fiscal conservatism may indeed hold sway with his boss. If it does, will Mr Bolsonaro be able to persuade a fractious congress to reform Brazil’s pension system, a big cause of its fiscal problems? What can he offer in return? Coming up with answers takes on-the-ground research.

This kind of intelligence-gathering is beyond the scope of the ordinary investor. But mutual funds based on benchmarks, such as J.P. Morgan’s emerging-market bond index (EMBI) of hard-currency debt, are broad enough to be considered by the non-specialist. The dozens of countries in the EMBI span a diversity of political risks. And the rewards are handsome. The spread of EMBI bonds over Treasury bonds is around 4.2 percentage points. And because in most emerging markets dollar bonds are not a big part of overall debt, there is little point in selectively defaulting on them.

Crunch points are rare, says Graham Stock of BlueBay Asset Management. Most of the time, things get a little better in some emerging markets, a bit worse in others. Brazil is different, however. If it does not take action quite soon, its debt ratio will spiral upwards.

Though this sort of binary (will-they-won’t-they?) political risk is now uncommon in emerging markets, it is increasingly present in the rich world. The euro’s viability depends largely on whether Germany and the zone’s other high-saving countries can agree to some form of fiscal union with others, notably Italy, whose debts loom larger.

At least, say the specialists, you are paid a premium for bearing political risk in emerging markets. It rankles that America has incurred no penalty for policies—a big unfunded tax cut; protectionism—that would sink a poorer country. That Steven Mnuchin, the treasury secretary, is also an alumnus of Goldman Sachs was no bar to recklessness. Something to bear in mind as Mr Guedes and his boss ready themselves for office.

Inverted Yield Curve - The Complete Picture

by: Dilantha De Silva

- An inverted yield curve is one of the most feared occurrences by stock market investors.

- History might repeat itself, meaning stocks might see a surge of around 21% before reaching the peak.

- Investors should reconsider their asset allocation strategies, which would be vital to minimizing the impact of a possible market pull-back.

An inverted yield curve is seen as a sure sign of an upcoming recession, particularly due to the fact that an inverted yield curve has preceded all recessions (9 of them) since 1955. As the yield spread between 03- and 05-year treasuries dropped below zero earlier this week, Dow tumbled 799 points while the S&P 500 declined 90 points in a single trading session, both representing a collapse of more than 3%. If we are to go by empirical evidence though, there is no reason to believe that an economic recession is right around the corner. It would be irrational on the part of investors to sell all what they own just because the yield curve inverted. By all means, the yield curve was flat for the best part of this year and an inversion was always imminent.
What is behind an inverted yield curve?
Tuesday's market reaction does not come as a surprise, even though analysts have been warning of the exact same phenomenon happening for the best part of last three months. I believe investors should identify and understand what is implied by an inverted yield curve.
Currently, there is a lot of emphasis on media channels as to how yield curve inversions have preceded economic recessions but there is little coverage of why this happens and the outcomes of an inverted yield curve.
An inverted yield curve generally occurs as authorities hike interest rates to cool down an overheating economy. Rising rates are expected to reduce business activities and inflation.
An inverted yield curve depicts the underlying bond market dynamics. When bond investors see bonds with long-dated maturities safer, they tend to invest in long-dated bonds rather than short-dated bonds. This results in a lower yield for long-dated treasuries as the United States Department of Treasury can easily sell these fixed income securities to investors, even at a lower quoted yield.
On the flip side, the Treasury Department gets forced to increase the quoted yield on short-dated securities to attract potential investors. This gives rise to an inverted yield curve.
Implications of an inverted yield curve
The spread between 10-year and 2-year treasury yields is considered the de facto yield spread in assessing the underlying economic situation in the U.S. While this spread has flattened over the last 03 years, it still remains positive.
Tuesday's market rout triggered as the yield spread between 05- and 03-year treasuries reached negative territory, which can be considered as the first major warning sign of a heating U.S. economy.
(Source - Bloomberg)
One of the major implications of an inverted yield curve is that lenders would be better off lending for the short term rather than for the long-term as short-term rates become attractive than long-term rates. This creates a monumental shift in capital allocation activities and businesses with long-term funding requirements find it difficult to secure funds for their projects. While this does not happen abruptly, historical evidence suggests that this happens with time and economic activities tend to cool down significantly, which will lead to an economic recession.
The second major implication of an inverted yield curve is the stage of the business life cycle of an economy.
(Source - Corporate Finance Institute)
An inverted yield curve occurs when the underlying economy is reaching its maturity. Rapid interest rate hikes can only be seen in an economic environment in which high growth is driving inflation upward.
United States inflation rate
(Source - Trading Economics)

Based on the recent yield curve inversion, we can confirm the belief that the U.S. economy is reaching its maturity, slowly but surely.
The third implication is the negative investor sentiment. An inverted yield curve is the result of a negative sentiment of the short-term outlook of an economy.
Empirical evidence points to an economic recession
While an inverted yield curve has preceded the last 7 recessions of the U.S. economy, investors are more likely to remember the bruises of the dotcom bubble and the financial crisis.
(Source - Visual Capitalist)
Investors should note that an inverted yield curve is by no means a cause of an economic recession.
Rather, it is an indicator of a weakening, unhealthy economy that is probably growing at an unsustainable rate.
There are quite a few facts supporting the thesis of a possible economic recession in the horizon, which are outlined and discussed below.
Unsustainable growth levels
The U.S. economy, over the last couple of years, has grown at a stellar rate. The question is whether such a high growth rate of GDP is sustainable in the long run.
U.S. GDP growth rate
(Source - Trading Economics)
The annualized GDP growth rates have risen, supported by quantitative easing that followed after the financial crisis and recent stimulus boost provided via tax reforms. The U.S. economy cannot continue to grow at historically high levels without attracting inherent risks such as high inflation, which will eventually overheat the economy. The current rate of growth might lead the economy to a recession in the near term.
Historically low unemployment levels
When unemployment rate falls consistently, not only does it indicate a strong economy but also a possible hike in average wages in the near future, as the demand for labor outpaces the supply of labor.
(Source - Trading Economics)
Rising debt burden

Government debt has risen over the years but would be meaningless as a standalone indicator. However, the debt to GDP ratio gives an indication whether authorities would be able to stimulate the economy through monetary policy changes. When the debt to GDP ratio increases beyond an acceptable level, authorities would be less incentivized to stimulate economic activities of the nation as the debt burden would already be high. Apart from this, private debt has also been trending upwards over the last couple of years.
United States gross federal debt to GDP
(Source - Trading Economics)
The trade war
Although there are signs of a possible trade deal between the U.S. and China to put an end to the trade war, there is every possibility of a further escalation of this trade war, if these two economic giants fail to finalize an agreement. The trade war will especially push inflation higher if this leads to a price hike by companies that are affected by the trade war.
Declining home sales
Home sales are a key indicator of the strength of an economy. In line with rising mortgage rates, home sales have continued to decline in the U.S., which is another sign of a weakening economy.
Home sales in the United States 

(Source - Trading Economics)
Yield curve inversion and stock market performance
It would be worthwhile to take a look at stock market returns following a yield curve inversion. Surprisingly, the stock market has continued to gain until after such an event and has peaked much later, after providing a return of around 21% on average.
(Source - Bloomberg)
This is a classic illustration of the economic life-cycle stage in which the inversion of the yield curve occurs. As an inversion occurs very late in the economic life-cycle, the markets obviously have more legs to go as short-term economic performance of the country would remain to be attractive, along with higher corporate profits, until corporate profits reach the peak.
However, this is by no means an indication of a possible investment opportunity. In fact, a stock market rally even after a yield curve inversion occurs, makes investing in stocks much riskier and susceptible to a significant wealth erosion when markets pull back.
Another important metric that should be assessed is the Shiller P/E ratio.
Alarmingly, the Shiller P/E ratio is close to the levels seen during Black Tuesday, during the Great Depression.
Shiller P/E ratio (S&P 500)
(Source - Multpl)
The ratio is much higher than what was reported during the Financial Crisis in 2008 as well but well below the dotcom bubble level.
In its own right, the Shiller P/E ratio or any valuation metric for that matter cannot provide any solid direction as to where markets are headed to, but at the same time, the current stock market is by no means cheap.
Investment strategy
During an economic recession, which might occur anytime within the next 5 years, stock markets will suffer as a whole and it would be very difficult to point out at which stocks to keep invested in.
However, as a rule of thumb, it would be better to invest in companies with following characteristics.
  1. Extensive operating history with a proven track record of weathering economic storms
  2. Cash rich and low level of debt
  3. Business operations based on consumer staples
Consumer staples industry becomes an attractive bet during times of recessions as these products are generally inelastic to price and income level.
Investors should anyways continue to have a focus on creating a diversified portfolio, which is an important aspects in achieving long-term sustainable returns.
In the period leading up to a recession or a stock market crash, investors would be better off investing in companies with an acceptable level of dividend yield and a high safety of dividends.
This will allow investors to bank in when the markets crash. Slowly but surely, investors should allocate an increasing portion of their portfolio to cash, as this would serve them the best when markets are hit by the impending crisis.
An inverted yield curve does not mean the end of a bull run in stock markets but rather, provides an early warning sign of an overheating U.S. economy. Upon identifying the underlying risks of the economic outlook of America, investors should rethink their capital allocation strategies and look for ways to balance portfolios and try to achieve sound diversification benefits. Companies that are trading at extremely high price to earnings ratios should be avoided, dispute the ability of these companies to grow exponentially under healthy economic conditions. During a recession, such cyclical companies would be hit the most.
Investors need not panic at this point in time but remain focused on the underlying fundamentals of the economy, even if we see another substantial rally in stock markets in the short-term. Such a rally will make investors more prone to error due to the hoarding effect.

The Pentagon Doesn’t Know Where Its Money Goes

The military finally submits to an audit, and the results are por

By The Editorial Board

The editorial board represents the opinions of the board, its editor and the publisher. It is separate from the newsroom and the Op-Ed section.

CreditCreditJames Yang

After decades of ducking the legal requirement that it undergo a thorough financial audit, the Pentagon finally opened up its books to 1,200 outside accountants and analysts. The report was recently completed, and here’s the good news: The Army Corps of Engineers (most of it, anyway) and the Military Retirement Fund passed the audit.

The bad news: The Army, Navy, Air Force and Marines and most other divisions failed, which means they were unable to show that they were properly keeping track of their finances and assets.

The Pentagon has long prided itself on being a “can do” organization, firmly committed to protecting the nation. But when it comes to husbanding the billions of taxpayer dollars that pay for the vast military establishment, defense leaders have had less exacting standards.

“We failed the audit,” Deputy Defense Secretary Patrick Shanahan told reporters with a curiously nonchalant air. “We never expected to pass it.” 
The Pentagon failed the audit largely because there are serious gaps in the financial controls that guide it, the world’s largest military organization. It has $2.7 trillion in assets (weapons, bases and such) and $2.6 trillion in liabilities (mostly the costs of military personnel and retirees). Basically, the auditors couldn’t account for where all the money went because of flaws in information technology systems.

That laxity — and the prospect of tax dollars flowing to boondoggles — would be concerning at any time. But it is especially worrisome when the federal budget deficit has skyrocketed to $779 billion — and the military is insisting it needs more money.

In a way, Mr. Shanahan’s attitude is understandable. The Pentagon is an enormous bureaucracy — three million people, 15,700 aircraft, 280 ships, 585,000 facilities at 4,700 sites worldwide, an annual budget of $700 plus billion — and some experts say that expecting a clean bill of health on the first audit was never realistic.

Yet the Pentagon had nearly three decades to prepare for this accounting Judgment Day. While federal agencies were mandated by Congress in 1990 to begin performing annual financial audits, the Pentagon resisted for so long that it became the last one to comply with the law. Private companies, accountable to shareholders, couldn’t get away with that.

But audits are hard work; most defense officials aren’t business experts; and to some, bookkeeping and other management operations just aren’t a priority in wartime, which since Sept. 11, 2001, has been a permanent state.
Most important, the Pentagon is skilled at bucking Congress, which is what it did all those years. This, even though the Government Accountability Office, a government watchdog, put the Defense Department on its list of agencies vulnerable to fraud, waste and abuse in 2015.
The Pentagon was granted a virtual blank check to fight terrorism, and it still gets most of what it wants. It accounts for more than half of the federal discretionary spending, with a budget greater than the military spending of the next seven countries combined, including China and Russia.

So what did the audit — which cost some $413 million and covered every military asset, from buildings, fences, storage tanks, planes, computers, spare parts, invoices, purchase orders and contracts — find?

There are major flaws in how the Pentagon handles its information technology. The flaws include failing to revoke the credentials of former employees and using systems that can be hacked.

Officials said the auditors accounted for all major military equipment, even discovering $53 million worth of uninstalled missile motors at Hill Air Force Base in Utah that were cataloged erroneously as “not in working condition.” That’s an improvement from January, when defense officials acknowledged that they had lost track of 39 Black Hawk helicopters.

But the Pentagon was found to lack the systems and controls needed to “provide assurance over the existence, completeness and the valuation of inventory and related property recorded in the financial statements.” In all, the audit identified 20 “material weaknesses” that “could adversely affect DoD’s financial operations.”

They discovered ineffective payment systems, outdated financial management information technology systems, and an inability to substantiate that Pentagon real estate assets were properly cataloged and valued, among other complaints. 
The auditors estimated that the Pentagon made “improper payments” — which lacked sufficient or appropriate documentation or approvals — of $957 million in 2017 and $1.2 billion in 2018. While even that larger amount is a fraction of the overall Pentagon spending, such payments grew by 25 percent over those two years, a worrying trend that needs to be reversed.

Anyone expecting the discovery of pilfered funds will be disappointed. The audit wasn’t looking for fraud — which generally refers to malicious illegal activities — and Defense Department officials said it found none. (Different audits examine different aspects of an organization.)

Its purpose was to determine whether accounts could be reconciled, making the results less sexy, perhaps, but still important. The inability to accurately track how money is spent makes it impossible to know whether precious resources are going to the right places, undermining the Pentagon’s ability to be successful in its far-flung missions around the globe.

But it would be misleading to imply that such an immense bureaucracy is not also experiencing actual fraud, abuse or waste. Cost overruns and performance issues with such major weapons as the F-35 fighter jet and missile defense systems have been well documented in the past, raising doubts about the Pentagon’s ability to responsibly manage taxpayer dollars.

And the Special Inspector General for Afghanistan Reconstruction has spent six years documenting more than $400 million in questionable costs, unfinished projects and poorly executed programs, and pursuing 132 criminal convictions, in Afghanistan, the site of America’s longest-running war.

Last month, for example, a former recruiter of language interpreters for the American military was charged in an alleged scheme to recruit unqualified interpreters to work with American combat forces in Afghanistan. And in September, the former owner of a now defunct marble mining company in Afghanistan was found guilty in federal court for his role in defrauding the Overseas Private Investment Corporation and defaulting on a $15.8 million loan.

The unfavorable audit results come at an awkward time. A recent congressionally mandated study reached the alarming conclusion that despite all the money spent on defense, the United States today is so weakened that it “might struggle to win, or perhaps lose, a war against China or Russia.” The study also found that America’s military superiority and technological edge over those two major adversaries has eroded. 
The Pentagon, defense hawks in Congress and defense contractors relentlessly push for bigger military budgets and will continue to do so. The commission that did the study recommended future annual increases of 3 percent to 5 percent above inflation, which could give the Pentagon a budget of $972 billion per year by 2024, a cumulative increase of 44 percent over the current budget, according to Taxpayers for Common Sense. But throwing more money at the Pentagon doesn’t automatically make it more effective. Nor does it translate into better national security, as America’s “forever wars” in Afghanistan and elsewhere demonstrate.

The nation needs to be more honest about the choices it is making (investing trillions more dollars in the nuclear arsenal is especially foolhardy) and realize that other investments — in diplomacy and development overseas, in job training and infrastructure projects at home — are also crucial to national security.

Defense Secretary Jim Mattis and his leadership team deserve credit for finally opening the books for an audit, thus providing a baseline against which the management of future spending can be measured.

Before rushing to push Pentagon spending even higher, however, Congress, which has shirked its vital oversight role, would be well advised to make sure that critical reforms are undertaken by a stubbornly change-resistant bureaucracy, so Americans can be certain their tax dollars are being spent effectively.

The New Risks in Risk Regulation

The received wisdom among financial regulators is that they are better off being able to say, “We told you so” if something goes wrong, and that there is little downside in occasionally issuing dark warnings. So should we be genuinely anxious about a spate of recent warnings from central banks and international financial institutions?

Howard Davies

tablet business people

LONDON – When I took over responsibility for banking supervision in the United Kingdom, in 1995, a wise old bird in the Bank of England (BoE) warned me that I would find it a thankless task. No newspaper ever prints a headline reading “All London Banks Safe and Sound this Week.” But if a problem occurs, it is almost invariably seen as a case of supervisory failure. Dozy watchdogs asleep at the wheel are a trope that trips quickly into journalists’ coverage.

Regulators are caught in a crossfire of conflicting expectations. Banks want to be left alone, unless they need help. Consumers and their political representatives want regulators to be aware of every transaction, ready to intervene in real time if any glitch occurs. In the years running up to the 2008 financial crisis, the pendulum swung toward the non-interventionist end of the spectrum. Today, “intrusive” has a positive connotation in the regulatory lexicon. But the need to strike a sensible balance remains.

The other point my wise old bird made was that the only way to generate a positive story about regulation was to warn of trouble ahead. “Regulators warned today that…” is a good lede for the Financial Times or Wall Street Journal. Editors get a frisson of excitement from worrying their readers.

Financial regulators and the international financial institutions have been following that sage advice a lot recently. As William Coen, the secretary-general of the Basel Committee, put it at a recent conference, citing former US Federal Reserve Chair Ben Bernanke, “for those working to keep our financial system resilient, the enemy is forgetting.” Coen went on to argue that, “the likelihood of a future financial crisis occurring only increases with time.” I suppose one can see what he means, though I wonder about the logic of that formulation.

The European Central Bank has weighed in with more specific concerns: “Vulnerabilities in financial markets continue to build up amid pockets of high valuations and compressed global risk premia.” The ECB is particularly concerned about the feedback loop to the eurozone from trouble in other markets. That concern centers on asset managers: Euro area investment funds are vulnerable to “potential shocks in global financial markets.”

The BoE has similar concerns about the price of risk. On its “Bank Underground” blog, which is fast becoming the most interesting of the BoE’s publications, you can find analysis of the evolution of risk premia. Using the prices of credit default swaps, it shows that investors are accepting less compensation for bearing given amounts of credit risk: compensation per unit of default risk has fallen by 20% since early 2016. Similarly, the volatility premium, defined as the price of options that insure against falls in the equity index, has fallen considerably. In retrospect, mispricing of risk was a flashing red warning sign that regulators and investors ignored in the run up to the 2008 crisis.

The International Monetary Fund has gotten in on the act, too. Even though its October World Economic Outlook presents a positive picture of global growth, the IMF, no doubt still conscious of the Panglossian view it offered in 2006, now warns that the world economy is “vulnerable to a sudden tightening of financial conditions” and that “equity valuations appear stretched in some markets.” In this context, “some” is IMF code for the United States. The US market’s share of global equity valuations is the highest it has ever been – a remarkable statistic given the declining US share of global economic activity.

How should we view all these warnings? Are the regulators genuinely anxious, or just covering their backs? The received wisdom among regulators is that they are better off being able to say, “We told you so” if something goes wrong, and that there is little downside in occasionally issuing dark warnings. Journalists rarely look back to check whether the dire outcomes the authorities pointed to actually came to pass. And even if they do check, regulators can always claim that the worst was avoided precisely because they had warned of the risk.

But the warning quotient has been rising in recent weeks. Should we be genuinely anxious, and begin battening down the hatches to prepare for a coming storm?

It is hard to be sure, of course, but reasons to stay awake at night are multiplying. While each emerging-market trouble spot – Venezuela, Turkey, Brazil, Argentina – has idiosyncratic features, a pattern is starting to emerge. A rising dollar, and an investment flight to the US, is accentuating these countries’ self-generated problems. And while the Fed’s interest-rate hikes could hardly have been more carefully signaled in advance, there are still concerns that the desired financial tightening in credit markets has scarcely occurred yet, and that, if and when it does, some borrowers could find themselves uncomfortably exposed.

Then there is the risk of a trade war. The World Trade Organization has – at last – warned that an intensified tariff war could result in a sharp decline in trade. That would be a serious blow to the Chinese economy, which is already slowing markedly for other reasons.

So the global economic risks now seem to be weighted on the downside, after a benign period. The one piece of good news is that if a recession (or perhaps more likely a period of below-trend growth) is in the offing, banks are significantly more strongly capitalized than they were the last time. We can, however, be less certain about the shadow banking sector, almost by definition. We may be about to discover whether the new credit creators, some of whom do not have to live under a rigorous regime of capital regulation, have priced risk correctly.

Howard Davies, the first chairman of the United Kingdom’s Financial Services Authority (1997-2003), is Chairman of the Royal Bank of Scotland. He was Director of the London School of Economics (2003-11) and served as Deputy Governor of the Bank of England and Director-General of the Confederation of British Industry.